You've contributed to your 401(k) on a regular basis and watched your account grow. But now you need cash for that home improvement project or long overdue vacation. If you're thinking about taking a loan from your 401(k) or similar retirement plan, you need to consider the true costs of doing so.
How It Works
According to a recent survey, almost 82% of participants in 401(k)s are in plans that permit them to borrow from their accounts. While loans may be allowed for any reason, many plans allow them only in specific situations, such as buying a house or paying for college tuition.
Most 401(k) plans allow you to borrow up to half of your account balance, but not more than $50,000. You make a loan to yourself and promise to pay back the balance plus interest at the fixed rate determined by your plan. Payments must be made at least once every quarter and are typically deducted from your paycheck-much the same as your 401(k) contributions. Federal tax law requires that you repay the entire loan within five years, the exception being if you use the money to buy a home, in which case you get up to 25 years (but not beyond your normal retirement date). The interest rate you'll pay is usually competitive, as the Internal Revenue Code requires that you charge yourself a "market rate" for the loan. The market rate is usually 1%-2% over prime and is considered to be the rate you'd pay if borrowing from a bank.
Is the Convenience Worth the Costs??
Borrowing from your 401(k) is much easier than borrowing from a bank because there are no credit standards to meet. Since you own the money in your account, you automatically qualify for the loan. In addition, some borrowers may find other sources of financing to be more expensive, in which case a retirement plan loan can save money in interest paid.
However, the convenience of these loans comes with strings attached. If you leave your employer, voluntarily or involuntarily, you will have to pay the outstanding loan balance within 60 days. Fail to do so and the IRS will treat the loan as an early withdrawal, charging you income taxes and an early withdrawal penalty of 10%. In the case of a job change, you may be able to plan ahead and pay off the loan within 60 days. But in the case of an unexpected job loss, getting the money to repay the loan on such short notice could be very hard, adding the pain of a difficult tax situation to the stress of being newly unemployed.
Even more fundamentally though, are these loans really a good deal? In most cases, they aren't. The reason is simple: when you borrow from yourself, you don't earn a true "return" on your money. The interest you "earn" for your 401(k) has actually come directly out of your regular paycheck. The interest isn't extra money-it's simply money taken from one pocket and put in another. There's more money in your retirement account, but less money in your paycheck. In fact, because the interest you pay is with after-tax dollars, you get the dubious privilege of paying tax on that money twice-once in your paycheck now, and again when it is withdrawn from the plan eventually as ordinary income.
