There seems to be several misconceptions when people inquire about taking out a loan from their 401k. The short answer to this question is typically no. However, there are times when it could be a more feasible option than the alternatives. It’s important to understand how a loan on your 401k works and why it may or may not be the best option for you.
First of all, not all plans allow you to take a loan out on your 401k. You may or may not have that option depending on your specific plan you are participating in. The general way a loan from your 401k operates is you can borrow up to 50% of your vested balance you have in your account. The longest term you can borrow the funds on are typically 60 months and you can usually have no more than 2 loans at any one time. The interest rate charged is usually based on the current prime rate and are usually 1% – 2% above prime. When you take the loan out, you are actually taking money out of your fund balance, which means whatever balance you are borrowing from your 401k is actually not invested. The interest rate you are paying actually goes back to yourself.
Some people think that paying themselves that interest back is better than paying interest on a second mortgage or a consumer loan or a credit card. While it is better than paying double digit interest rates or paying on a loan that the interest goes to the financial institution, you are actually robbing yourself of future growth potential of your retirement and costing yourself more in taxes than you realize. Let me explain. When you take that loan out, and your money is taken out of your investment vehicle, you are missing out on potential gains your money could have made over the life of that loan. That’s money that you can never get back. The next biggest issue is that when you pay your money back to the loan, the loan payments are coming out after taxes. Now you are taking after tax money and putting it back into a tax deferred vehicle that you will have to pay taxes on in the future when you withdraw your funds for retirement. You are causing that money you took the loan on to be double taxed when you pay it back. These are the two main reasons 401k loans are typically not the best for most people. However, there are some circumstances when they may be necessary.
It’s important to makes sure you have a healthy emergency fund, with anywhere from 3-12 months of your monthly non-discretionary expenses saved up. Sometimes events may occur in our lives that warrant us to look at all options available to help us financially navigate through them. If you find yourself in a situation where your emergency funds cannot cover the circumstances, take some time to evaluate all of your options before you look at your 401k loan. If you have a home equity line of credit, you may want to consider that option sine the interest rate may likely be less, your payment may be more forgiving because you can amortize it longer, and the interest is deductible. If you do not have a home equity option, then you may look at other low interest loan options to help you through the situation. I think its best to weigh all of your options before choosing the 401k loan. You could always choose another option at first and if you’re not comfortable with it after some payments, then you can default back to the 401k loan. I would also recommend the 401k loan before cashing in other retirement funds that may create a tax consequence plus a penalty. The only time I think the 401k loan if reasonable to consider is when you have no other funding options available. You should also never use a 401k loan to purchase wants like a vehicle, boat, or toy.
Please remember to consult your tax professional and financial professional before making these kinds of decisions.