Can I take a loan from my 401k?
Feel like you’re at the corner of “can I take a loan from my 401k?” and “will I hurt my retirement savings if I do?”
Well, you’re not alone. Each year many hard working Americans wonder the same thing.
In fact, during the fiscal year of 2014, 11% of employed Americans took out a 401k loan.
And if you weigh your options correctly, it can be a smart idea.
I mean, think about it. Technically, a 401(k) loan is money you borrow from yourself. Who wouldn’t prefer that to borrowing from a bank?
However, the important thing to keep in mind is that every loan, whether it is a 401k, mortgage, or car loan, comes with strings attached.
And every string has the potential to become a problem if you make an uninformed decision.
So the key is to know all of the facts before you decide to take out a 401k loan. That way you can determine if it’s the right type of loan for you.
How do 401k loans work?
To find the answer to the question, “Can I take a loan from my 401k,” you must first know if your employer sponsored plan allows for it.
While loans have become a popular option, not every plan features the ability to take one out.
Want to know a secret? Finding out if a loan is available to you is probably the hardest part of the entire process. Things only get easier from there.
In other words, the 401k loan process so ideal because there are no hoops to jump through.
Approval for a 401k loan does not require much other than being approved by your plan administrator (unless of course, you have somehow managed to make an enemy of 401k sponsor…then you might want to refer to an article about begging for forgiveness and hoping for the best).
Once you’re approved for the loan, you receive the money. It’s that simple.
Inevitably, the question that follows “can I take a loan from my 401k” is “how much?”
You should be aware that there is a limitation on the amount you can borrow.
You can only borrow half of the vested amount in your account, or a maximum of $50,000, depending whichever is less.
Also, don’t forget that you typically have five years to repay the loan, so borrow only what you can pay off within that time frame.
Reasons to take out a 401k loan
So now you’re wondering, “under what circumstances can I take a loan from my 401k?” The answer is many.
And in those situations there are several incentives to doing so.
Typically speaking, 401(k) loans work best for short-term needs, where you can repay the money quickly.
Some of the best reasons to take out a 401(k) loan include:
- Purchasing a home
- Pursuing higher education
- Financing a business or investment
In some cases, you might be eligible for a loan extension if you used the money as a down payment on a house.
“That’s great,” you’re saying, “but can I use my loan to help alleviate financial hardship?”
You might be especially curious about this question if you owe money in back taxes to Uncle Sam.
In most cases, you can use the money however you want, including paying for taxes.
This can be an appealing option if the amount of interest you’ll pay (to yourself, nonetheless) is smaller than potential tax penalties.
However, some plans do place restrictions on how the money can be used. Before you take out a loan make sure you know if such restrictions exist and what they entail.
More importantly, be wary of potential downsides linked to borrowing money from your 401k.
One of the biggest problems with borrowing from your 401k is that you lose out on potential earnings.
Take money out, and it can no longer grow.
While this might seem like a small hiccup, especially if retirement is a long ways away, it can have an impact.
Many Americans don’t set aside enough money for retirement to begin with, and borrowing the money now can mean you have less for the future.
Remember, when you retire you’ll be on a fixed income and you’ll need a savings to fall back on.
That’s why it’s really important to think twice before you take money out.
Other issues can arise with your 401(k) loan if you lose (or leave) your job.
Leaving the employer that sponsors the plan while you have an outstanding loan means that you will be required to repay the loan within 60 days.
Failing to do so means the borrowed amount will be considered as an early withdrawal of your retirement, making the funds subject to 10% early withdrawal penalty and income tax based on your normal rate.
However, if you’re certain of your job security and feel that you can repay the money quickly, 401(k) loans have many advantages.
One thing that makes a 401k loan so convenient is the ease in which you can be approved for the loan.
401(k) loans are also subject to lower interest rates. Even more compelling: any interest you pay on the loan, you pay to yourself.
Interest you pay is returned to your 401k account along with your monthly payments.
However, you’re the only one who can determine whether the benefits outweigh the significant costs.
When it comes to your retirement, don’t put off saving money.
The more money you accrue now, the bigger your future safety net.
And while you should think hard about a 401k loan, it’s key that you make the best decision to maximize the amount you have save for retirement.
If that means taking out a loan now to resolve financial hardship, pay taxes, or make an investment that can add to your savings later, then proceed with caution.