The Advantages and Disadvantages of 401(k) Loans

Tapping your tax-advantaged retirement savings seems like a desperate financial move (because it is), yet also a sound one in specific circumstances. It’s best to know what you get into with 401(k) loans in terms of time, payback, and risk.

Many holders of 401(k)s do in fact tap their accounts. According to 401k.org, about 20% of Americans eligible for a 401(k) loan have one, with balances averaging close to $7,000.

The amount of your loan usually starts at about $1,000 and maxes out at $100,000 (previously, it was $50,000 or 50% of your vested account, whichever was less, but that changed in 2020). While interest rates vary by plan, the most common is the prime rate plus 1%.

Unless you borrow to buy a home, you must fully repay most 401(k) loans within five years, often on a monthly schedule. Usually, you repay directly out of your paycheck on an after-tax basis and may repay all at once with no penalty.

Advantages

• The loans incur no income tax or penalties for early withdrawal unless you default.
• There is no credit check or long application form, opening options if your credit scores are bad.
• Most loans become available quickly and you can borrow for almost any reason.
• Most 401(k) loans come with interest rates cheaper than what credit cards charge.
• You pay interest on the loan to yourself, not to a bank or other lender.

Disadvantages

• To borrow money, you remove it from investment in the market, forfeiting potential gains. Calculate your potential losses carefully.
• Borrowed funds are taxed twice. You earn and pay taxes on wages and use those after-tax funds to repay the loan. During retirement, you again pay taxes, this time on withdrawn funds. If you’re in the 25% federal tax bracket, twice the tax is extremely expensive.
• You ultimately contribute less to your retirement plan because a portion of new contributions goes toward paying off the loan.
• Not all 401(k)s allow employees to borrow from the accounts. Check with your human resources department before you even begin to consider a loan.
• If you cease working with your current employer, your entire loan usually comes due within 60 days – making your job security for the next five years a big consideration. The loan defaults if you can’t repay so you pay tax on the outstanding amount and incur a 10% early withdrawal penalty until you reach age 59½.

Considerations

You might consider a 401(k) loan if you have looked at all other financial resources and options, including home-equity loans.

That said, sometimes a 401(k) loan offers a situation-specific solution. For instance, maybe you expect an inheritance within the next few months and want to purchase a new home immediately.

It might make sense to borrow from your 401(k) to cover the initial cost of the home loan and repay the loan in full once you get the inheritance. This potentially helps you to borrow funds inexpensively and maintain the benefits of your retirement plan. Again, the length of the repayment period can loom large.

Education and business capital are also potential reasons to consider – carefully – a 401(k) loan. The point: Make sure you understand what you could stand to gain in the present justifies the potential risk to your future financial security.

Your financial professional may be a helpful sounding board for you to weigh the advantages and disadvantages of 401(k) loans.

Important Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

This article was prepared by FMeX.

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