Question of the week:Money is tight and I'm thinking about taking out a loan from my 401(k). Borrowing from myself--and paying the interest to myself--seems like a no-brainer. What do you think? --2LT
Dear 2LT,
You're not alone in considering this. According to Hewitt Associates, a major HR consulting firm, 94 percent of all 401(k) plans are set up to allow loans. And plenty of people take advantage of them-nearly one out of every five people with a 401(k) has a loan outstanding.
When we asked members of the Armchair Millionaire community about the wisdom of borrowing from a 401(k), we got mixed reviews:
"We did it at a good time when interest rates were very low, so we were actually making money when we paid ourselves back. However, the headache and frustration of knowing the money has to get back in there really wasn't worth it." --Bobbi T.
"No how, no way! Keep your mitts off your 401(k) unless in dire emergency. That's sacred money for old age!" --Betty
My opinion is that, in most cases, you should stay away from borrowing from your 401(k). While you're right that the interest payments you make go right back to yourself, it's important to consider the drawbacks:
- If you quit or are fired, you'll have to pay the loan back in full immediately--usually not a great situation when you've just left a job.
- You make your loan payments with after-tax money, but when you take distributions from your 401(k) upon retirement, you'll still owe tax on all that money. This means you'll end up paying taxes twice on the money used to pay back your loan.
- You miss out on the growth of your investment. Compounding returns are the magic ingredient for building your retirement fund, and you lose them when you take your money out for the loan. Depending on how much you borrow, you could end up with a significantly smaller nest egg.
I suggest you only borrow from your 401(k) if you absolutely must. For example, if you have an emergency on your hands and no other available funds. My guide provides the essentials of what you'll need to know.
The Armchair Millionaire Guide to Borrowing From Your 401(k)
Interest. Rates are usually competitive with other kinds of loans-a point or two above the prime lending rate. Your principal and interest payments will be automatically deducted from your paycheck and put into your 401(k) account. The interest is not tax deductible.
Loan amount. You can usually borrow up to $50,000 or one-half of your contributions and vested employer contributions, whichever is less.
Repayment. You typically have to repay the loan within five years, although your plan might allow a longer term if you're using the money to buy a home.
Defaulting. It's going to hurt if you fail to repay your loan. The unpaid balance will be treated like a distribution from your plan, meaning you'll have to pay income taxes on the amount and, in most cases, a ten percent early withdrawal penalty.
THE BOTTOM LINE: Borrowing from your 401(k) is not a brilliant financial move, but it could save your hide if you have no other alternatives. If you do borrow, know the rules, pay it back as soon as you can and, if possible, keep contributing to your plan.
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