What You Should Know About 401 (K) Loans

According to 401k.org, about 20% of Americans eligible for a 401k loan have one, and the average outstanding loan balance is $ 7,600. Since 401k loans are an option for many, it is a good idea to familiarize yourself with this tool. Also, keep in mind that not all 401 (k) plans allow employees to borrow from their accounts. Check with your human resources department before you start considering a loan.

The maximum loan amount allowed is restricted to half of the vested account balance or $ 50,000, whichever is less. Although interest rates vary by plan, the most common rate is the prime rate plus one percent. Unless slow funds are used to buy a home, most 401k loans must be repaid in full within five years.

The advantages:

• Loans are not subject to income taxes or early withdrawal penalties (unless the loan is defaulted).
• Loans are convenient. There is no credit check and no lengthy application form.
• The loans have low interest rates. Most 401k loans are cheaper than the rates charged by credit cards.
• Interest paid on the loan is paid to yourself, not to a bank or other lender.

The disadvantages:

• The borrowed money will not be invested in the market, so potential investment earnings will be lost.
• Borrowed funds will be taxed twice! Borrowers earn wages, pay taxes on those wages, and use those after-tax funds to pay off the loan. During retirement, the retiree will again pay taxes on the withdrawn funds. Consider an investor who falls into the 25% federal tax bracket – paying taxes twice would be extremely expensive.
• Investors with a 401k loan ultimately contribute less to their retirement plan because a portion of the new contributions will go toward repaying the loan.
• If you stop working with your current employer, your entire loan is generally due within 60 days. If you are unable to repay the loan, it is considered delinquent and you will be taxed on the outstanding amount and you will be subject to a 10% early withdrawal penalty if you are under age 59½.

In general, I believe that a 401 (k) loan should be considered only if it is essential and all other financial resources have been exhausted. However, there are cases where a 401 (k) loan can be a great solution. For example, I have a client who expects to receive an inheritance in the next few months. However, this client would like to buy a new home right away and needs funds for the down payment. It makes sense for this client to borrow from their 401 (k) plan to cover the initial cost of the home loan and pay off the loan in full once the inheritance is received. This allows this person to borrow funds cheaply, but without losing out on the great benefits that their retirement plan provides.