It sounds so simple. You need some quick cash because of a financial emergency and you decide to borrow from your 401(k) retirement plan. After all, it's your money and the interest and principal you pay goes back into your account. But as with most financial issues, it's not as simple as it sounds.
In fact, for most people, borrowing from a 401(k) is not the best solution. Yet, if you've got a financial emergency, and your only choice is between borrowing from your 401(k) plan and pulling the money before you're age 59 1/2, then it's a no-brainer. By all means, borrow the money. That's because there is no penalty on borrowing, yet there is a 10% penalty on early distributions, plus tax liabilities.
If your 401(k) plan allows loans (many do), you can borrow up to 50% of your vested account balance or $50,000, and whichever is less. You usually have a maximum of five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback.
Now, let's go through the pros and cons of borrowing from your 401(k):
- There is no credit check. You don't have to apply for the loan, and you can make plans knowing that you will get the loan.
- There is a low interest rate. You pay the rate set by the plan, usually a couple of percentage points above the prime rate.
- It's convenient. Some plans only require you to make a phone call, while others require a short loan form.
- You're spending your own money. Remember that you aren't really borrowing. All you are doing is using money from your 401k account, and creating an obligation to pay it back, like a credit card. Like a credit card, it is not tax deductible.
- It's not tax-sheltered money anymore. Whether you repay the 401(k) loan out of your salary or from a bank account, those payments are all paid back into the 401(k) with after-tax dollars. So, let's say your monthly payment is $300 and you're in the 25% tax bracket. You'll have to make $400 in gross earnings to make the $300 payment. Then, when you retire and take withdrawals, you pay taxes yet again! TWICE !!
- Unless you repay the loan, it is considered a premature distribution. You will owe federal and state income taxes as well as that 10% penalty if you are under age 59 1/2.
- It affects your psychology and habits toward retirement saving. If possible, your retirement money should sit untouched until you retire.
The bottom line: the 401(k) should be the last resort. Like your "root cellar", you should only eat from it when you must; otherwise it might not be there when you need it most.