Many American employees are provided with 401(k) retirement plans from their employers. When tough times come and you are strapped for cash, it can be tempting and seem like a good option to borrow money from your 401(k) plan. That is not necessarily the case. Before you make such a decision it is important that you fully understand the tax consequences and penalties that you might incur from borrowing. This article will briefly cover some of the information that you need to know before you make the decision to borrow from your 401(k) plan.
Before you can take a loan you must first find out if you are even allowed to borrow from your 401(k) plan and if you are what circumstances must you be under to do so. Some 401(k) plans only allow you to borrow if the face of financial hardship; while others may allow you to borrow so that you can buy a car as your current one is very old, make home improvements like a new front door (you can look here to see about this), or to use for other purposes. If you want the exact circumstances you can meet with your plan administrator or read the summary of your plan description.
How Much Can You Borrow?
As a general rule of thumb, you will not be allowed to borrow the entire sum that your 401(k) plan is worth. You usually cannot borrow more than $50,000 or one-half of your vested benefits, whichever is less. It is also important to note that to borrow from your plan does not typically involve a lot of paperwork on your behalf and typically involves very little in the way of fees.
Repaying the Loan
Generally, you will be required to repay the amount borrowed within 5 years. You will have to make payments of principal and interest at least every quarter. These payments are typically done through a payroll deduction. The only time this may differ is if you use the money towards purchasing a primary residence. In this case, you will have a longer time period to repay your loan.
Correctly repaying the loan is extremely important because money not repaid as required is considered taxable. If you are under 59 this means you will have to pay a 10% penalty, on top of the required income tax that you owe on the improperly paid portion.
Borrowing Advantages and Disadvantages
As with any financial decision you make, you have to weigh the costs and the benefits to finding if a decision is right for you. Here are a few advantages and disadvantages to consider before taking a loan from your 401(k).
- Don’t pay taxes and penalties on the borrowed amount, as long as your properly repay the loan
- Interest rates on your loan will be in line with the rates banks or other institutions would charge for a similar loan
- Typically, the interest you pay will be credited to your account. So you are earning additional interest, not the bank or lender.
- If your loan is not paid back in time it will be treated as a taxable distribution
- If you leave your current employer (whether you quit or you are fired) and you have a remaining loan balance you will be required to repay the loan in full within 60 days. If you are not able to repay the remaining balance will be treated as a taxable distribution.
- Loan interested is not tax-deductible
- You will lose out on any interest earning that may have accrued on the funds that you borrowed if they had remained in your 401(k) account.
- Loan payments are made with after-tax dollars, the money you put in was made with before-tax dollars.
Now that you understand some of the benefits and consequences of borrowing from your 401(k) plan you will be better equipped to make an educated decision. If you are still unsure or need more information meet with your plan administrator or your financial planner for help in answering your questions in detail.