A 401 (k) plan is a great place to borrow funds for a short-term emergency or large purchase. However, there are pros and cons to doing this. And in some instances, there are risks.
What Is a 401(k) Loan?
A loan from your 401(k) is not a true loan. There isn’t a lender, and you don’t need to worry about your credit history. It’s just an opportunity to access your retirement savings early. When you repay your loan, you will have restored your 401(k) plan to its previous condition.
A 401(k) loan can be for up to $50,000 or 50 percent of your vested balance, whichever amount is smaller. The interest rate is usually determined by the plan administrator, based on the prime rate.
When you borrow from your 401(k) plan, it’s considered a short-term loan. It must generally be repaid, with interest, within five years. But since the interest is technically going from your pocket, back into your pocket, it doesn’t ultimately cost you. You own the principal and the interest.
Whether you can borrow from your 401(k) depends on your plan administrator. In addition, in some cases, you are not allowed to contribute to a 401(k) plan if you have an outstanding loan, which could inhibit your retirement planning.
A 401(k) loan does not interfere with your credit score, because you are borrowing from yourself, not from a lender. As a result, if you default on the loan, it won’t be reported to a credit bureau and won’t affect your score.
When considering a 401(k) loan, you may fear that the principal will be taxed and then taxed again at later withdrawal. The concern is double taxation.
When you take a loan from your 401(k), the principal is not taxed.
However, unlike 401(k) contributions, which are made with pre-tax dollars, repayments to a 401(k) loan are made with after-tax dollars. When you ultimately begin taking distributions from your 401(k), the interest paid will be taxed again—so in this sense, a 401(k) loan does involve double taxation.
However, if you compare a 401(k) loan to a conventional loan—which will also be repaid with after-tax dollars—you will still come out ahead because the interest you pay will go into your pocket, not someone else’s.
The Stock Market Could Influence Your 401(k) Loan
During a bear market, there is an advantage to borrowing from a 401(k) plan. If you think the stock market is going down, you’ll be selling your assets at a low cost to cover the loan. Then in most instances, you’ll pay yourself back with a higher interest rate than your money would have earned. This will allow you to avoid any further investment losses on those assets. In the meantime, it lets you use your money for short-term needs.
There are risks to borrowing from your 401(k) during a bull market. If you borrow when the bull is running, and the market is strong, you could miss out on gains that the money you borrow from your 401(k) could have made. And if your 401(k) includes high-interest bearing options, the low-interest rate you are paying back into the fund may not offset your loss.
Sometimes, borrowing from a 401(k) plan has a neutral effect on your 401(k) balance. That’s because the interest you are paying may be the same as what the stock market is earning. Therefore, it could be a wash.
Who Should Take Advantage of a 401(k) Loan?
You may want to borrow from your 401(k) plan if you have a short-term liquidity need. In other words, if you need cash quickly for the short-term, and know you can pay it back within five years, this may be a good move. Because of the 401(k) loan’s lower interest rate, it is less expensive than taking out a personal loan or even worse, a payday or pawn loan.
401(k) Loans for Home Purchases
Although the IRS requires that 401(k) loans be paid back with interest over five years, taking out a 401(k) to purchase a home has different terms. The IRS allows for a longer payback when the loan is used for purchasing a primary residence. However, the IRS doesn’t designate the duration of the payback period. This is up to the plan administrator.
A 401(k) loan for a home purchase may offer a lower interest rate. In addition, the application process for a 401(k) loan is quicker than that for a traditional loan.
Student Loan Repayment and 401(k) Loans
Many former students are burdened with large student loans. The average individual takes about 20 years to repay a student loan.
It may be tempting to borrow from your 401(k) to quickly pay off your student loans. However, the interest rate on U.S. government-backed student loans is usually lower than that on a 401(k) loan.
It may be wiser to see if you qualify for a deferment or forbearance on your student loan, or apply for an income-driven repayment plan. A deferment or forbearance may last for up to three years, although you may have to pay accrued interest.
When considering borrowing from your 401(k) for student loans, evaluate the payback period and interest rates. It may not be worth it.
Changing or Losing a Job Changes Loan
Changing or losing your job will affect your options for a 401(k) loan.
If you are working, your 401(k) loan repayments are made through automatic payroll withdrawals. If you leave your employment, whether the move is voluntary or involuntary, you will be responsible for making these loan payments on your own.
Moreover, if you have a 401(k) loan, and then leave your current job, regardless of the circumstances, the repayment period will change. According to the Tax Cuts and Jobs Act of 2017, you will now have until your next tax return due date to pay off the loan.
If you don’t pay the full balance back on time, your loan will be considered an early withdrawal. The loan balance will be deemed a taxable distribution, subject to taxes and penalties.
Can You Borrow From an Old 401(k)?
If you have a 401(k) from a former employer, you won’t be able to borrow from it unless you have rolled it into your current 401(k) plan. As with any 401(k), you can withdraw funds from it, but you’ll have federal and state taxes to pay. There will also be financial penalties if you are not fifty-nine and a half years old. It will cost you.
To sum up, a 401(k) loan may be a viable solution if you have a short-term need. But be aware of the benefits and risks. In particular, if you are considering leaving your job, you may want to make other arrangements.
The Epoch Times Copyright © 2022 The views and opinions expressed are only those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.