Advantages and Disadvantages of Borrowing From Your 401(k)

Advantages and Disadvantages of Borrowing From Your 401(k)

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If you are a contributor to a 401(k) account, congratulations! You are using an effective way to save money so that you can enjoy it in the future, and even in the present. Many ask, “How can I get money out of my 401(k)?” and the answer is taking out a loan. Taxpayers can use this money to increase their liquidity, invest or face an unforeseen expense. If you’re thinking, “I need money from my 401k,” then keep reading to learn how to take out loans from your 401(k).

Although it’s a valid option, taking out loans from your 401(k) account also has its drawbacks. Depending on the particular case, it could be more expensive than you imagine or could even affect the growth potential of your investment. Therefore, before requesting a loan from your 401(k) account, it is essential that you understand what it is, how it works and what benefits you could obtain.

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How do 401(k) loans work?

Not all 401(k) investment plans allow beneficiaries to apply for loans. To find out if your 401(k) account has this option enabled, you need to review your membership plan information. Suppose your plan allows the request for loans. In this case, any amount of money you request from your 401(k) account must be paid within a certain period.

So what’s the difference between taking out loans from your 401(k) and applying for a bank loan? That, in this case, you are borrowing money that is already yours. Therefore, you will have to pay yourself and with interest.

Features of 401(k) Loans

Let’s look at some of the main features of loans requested from 401(k) accounts:

  • The maximum loan amount is $50,000. 401(k) accounts allow beneficiaries to request a loan equivalent to up to 50% of the accumulated balance, but as long as it does not exceed the maximum limit established, which is $50,000. Let’s look at an example: Imagine you have $150,000 in your 401(k) account. In this case, 50% of your accumulated balance would be $75,000, but you will not be able to request this full amount, as the limit is $50,000. What happens if you have less money accumulated? Then you can request up to 50% of your current balance. Depending on your particular situation, they may allow you to request a little more than 50% of your 401(k) account balance, but this will only be possible if you have an exceptional situation.
  • The maximum payment term is 5 years. At least in most cases. The only situation that contemplates a longer term (up to 25 years to pay) is if the applicant needs the money to buy a house that will become his main residence.
  • Payments must be made quarterly. Requested loan payments to 401(k) accounts are fixed and are made quarterly. One of the advantages offered by this type of loan is that it allows you to make payments adjusted to the amount of your paycheck after tax deductions.

How to request a loan from your 401(k) account?

Once you make sure that your 401(k) account allows the request of loans (and in case you want to request them) you will have to contact the administrator of the funds directly. Authorized agents will give you all the information you need to know in order to take out a loan from your 401(k) account.
If the fund manager approves the loan, you will have to sign an agreement that will include all the details and conditions, such as the principal amount of the loan, the payment term, the interest rate applied and any other fees or commissions applied.

Remember: If you’re married and want to borrow more than $5,000, you may need your spouse’s consent.

401(k) Loans: Advantages and Disadvantages

While taking out loans from your 401(k) account can be an affordable way to get cash right away, you should consider its drawbacks. Only then can you make the right decision and, at the same time, protect your assets.

Advantages of borrowing from your 401(k) account

Compared to other types of loans, lines of credit, and cards, 401(k) loans typically have a lower associated cost. Consider that instead of paying interest to a lender, you would be paying interest to yourself. Therefore, your current balance will rise and you will be able to enjoy it in the future.

This feature makes 401(k) loans better than other forms of credit, such as credit cards or high-interest loans. Remember that, although 401(k) loans are subject to a variable interest rate, it is much lower than what traditional banks handle for personal loans. Of course, this isn’t the only advantage of using your 401(k) account as a funding method. Let’s look at some others:

  • A credit check will not be required. This has a double benefit. On the one hand, your credit rating will not negatively affect the interest rate set by the fund manager, and on the other, your credit score will not be lowered as a result of a “hard inquiry”. Therefore, your points will not decrease at all.
  • Approval is much faster. By not checking your credit score, and by applying for a loan from your own savings, approvals are often quicker than normal. This will help you a lot, especially if you need to access a quick amount of money.

Disadvantages of borrowing from your 401(k) account

Among the disadvantages that you could find when requesting a loan from your 401(k) account are the following:

You will lose money for the investment

When you take out a loan from your 401(k) account, you reduce the amount accumulated. What does this mean? That money will no longer be available to invest. Depending on the payment term chosen, you would lose from 5 to 25 years of possible earnings. Worst? There is no way to calculate how much money you would be losing, since the return on investment will depend on many factors.

If you decide to reduce or stop contributions, you could lose benefits.

Keep in mind that every time you contribute to your 401(k) account, you are entitled to ask your employer for a refund. If you stop or reduce the amount contributed, you will not be able to do this.

If you fall behind on payments, you could be fined

Another downside to borrowing from your 401(k) is that if you default, the fund manager could see it as a readjustment to your retirement plan. Therefore, you would have to pay income taxes on the full amount of the loan basis. Unfortunately, this would not be the only problem, since considering it as an early withdrawal, you would have to pay an additional penalty equivalent to 10% of the total amount of the loan. (As long as you’re under 59 and don’t qualify for any exceptions.)

Problems paying if you become unemployed

If you quit or are fired from your job and have not yet finished paying off the loan, you may be required to pay the remaining credit balance in full. This is a mechanism used by retirement fund managers to protect you. If you are unable to repay the amount in cash, a “fund redistribution” will be applied just as it would be if you defaulted on the loan. To avoid paying taxes at adjustment, transfer your loan balance to an eligible retirement plan on your federal income tax filing date.

Remember: If you do not pay your loan, you would be substantially reducing the amount of your retirement fund. Any amounts you miss will be deducted from your total 401(k) account balance.

In conclusion, is it a good idea to take out loans from your 401(k) account?

There is no absolute answer to this question. If your financial situation is solid, but you need immediate liquidity, requesting a loan from your 401(k) account could be the best alternative. Especially if you compare it with other financial instruments and you need the money to pay off a debt contracted at a high interest rate or to cover an important expense. If your case does not fit into any of these assumptions, perhaps requesting a loan from your 401(k) account is not the best option, since it may end up costing you much more, this without taking into account the loss of dividends and the penalties for default.

Our recommendation? Before taking out loans from your 401(k) account, consider other alternatives. For example, you can request a mortgage loan or a personal loan. If you are determined to request the loan from your 401(k) account, do not forget to carefully read the terms and conditions, in addition to analyzing whether you can meet the payment of the installments within the agreed term.