As you’re well aware, we’re living in difficult economic times. Consequently, you may be forced to make some financial moves you wouldn’t normally undertake. One such move you might be considering is taking out a loan from your 401(k) plan — but is this a good idea?
Of course, if you really need the money, and you have no alternatives, you may need to consider a 401(k) loan. Some employers allow 401(k) loans only in cases of financial hardship, although the definition of “hardship” can be flexible. But many employers allow these loans for just about any purpose. To learn the borrowing requirements for your particular plan, you’ll need to contact your plan administrator.
Generally, you can borrow up to $50,000, or one-half of your vested plan benefits, whichever is less. You’ve got up to five years to repay your loan, although the repayment period can be longer if you use the funds to buy a primary residence. And you pay yourself back with interest.
However, even though it’s easy to access your 401(k) through a loan, there are some valid reasons for avoiding this move, if at all possible. Here are a few to consider:
You might reduce your retirement savings. A 401(k) is designed to be a retirement savings vehicle. Your earnings potentially grow on a tax-deferred basis, so your money can accumulate faster than if it were placed in an investment on which you paid taxes every year. But if you take out a 401(k) loan, you’re removing valuable resources from your account — and even though you’re paying yourself back, you can never regain the time when your money could have been growing.
You might reduce your contributions. Once you start making loan payments, you might feel enough of a financial pinch that you feel forced to reduce the amount you contribute to your 401(k).
You may create a taxable situation. Failure to pay back loans according to the specified terms can create a taxable distribution and possibly subject the distribution to a 10 percent penalty.
You may have to repay the loan quickly. As long as you continue working for the same employer, your repayment terms likely will not change. But if you leave your employment, either voluntarily or not, you’ll probably have to repay the loan in full within 60 days — and if you don’t, the remaining balance will be taxable. Plus, if you’re under age 59½, you’ll also have to pay a 10 percent penalty tax.
Considering these drawbacks to taking out a 401(k) loan, you may want to look elsewhere for money when you need it. But the best time to put away this money is well before you need it. Try to build an emergency fund containing at least six to 12 months’ worth of living expenses, and keep the money in a liquid vehicle. With this money, you’re primarily interested in protecting your principal, not in earning a high return.
A 401(k) is a great retirement savings vehicle. But a 401(k) loan? Not always a good idea. Do what you can to avoid it.