It happens to many people, and it can happen to you, too.
You're in a crunch, and could use some quick cash as a bail-out. The bank account is thin, you don't want to apply for a personal loan and pay those high interest rates, and you (probably) don't have a trust fund.
The last option on the table for cash-strapped individuals is their 401(k) plan, often stuffed with cash. Should you borrow from your 401(k)? Hey, you may be 20 years from retirement, and borrowing from your 401(k) is no problem - you can easily pay the money back.
Why not? It's almost as if 401(k) plan providers make it too easy to borrow from your 401(k).
In fact, most 401(k) plans let you borrow up to half the balance (or $50,000 - whichever is less), with a five-year period to repay the loan - or longer, if you're using it to buy your first home. Interest rates are usually only a few points above the prime rate. There's no credit check required, and with some plans, your money is only a pushed button or tab away.
The concept doesn't sound so onerous, either. You borrow the money from the best lender you know - yourself - and pay yourself back the cash, with interest.
The fact is, borrowing from your 401(k) is usually only a good idea when you're in extreme financial risk, i.e., your home is about to repossessed, for example, or it's the middle of winter and your hot water heater goes bust, and you need the money to keep your house warm and safe. It's also doable when you stand to made a financial decision that could change your life, like the purchase of your first home.
The downsides, though, are many. You eat into your retirement savings, potentially incur the wrath of the Internal Revenue Service with taxes and penalties, and have to come up with the cash somewhere or you risk not paying the 401(k) loan back.
Still, if you absolutely must borrow from your 401(k) plan in the event of a financial emergency, at least do it for the right reasons, and handle the entire 401(k) loan experience correctly - without getting the IRS involved and without gutting your 401(k) plan.
Here's how to get the job done right.
What Is a 401(k) Loan?
A 401(k) loan is literally a personal loan taken out by you, against the proceeds in your 401(k) plan.
By IRS statutes, you can borrow up to $50,000 from your 401(k) plan, if you have a minimum of $100,000 in your 401(k), or you can borrow 50% of your plan proceeds.
401(k) loan borrowers should know that 401(k) loan rules can be different on a company by company basis. Usually, though, there is no credit check involved (after all, you are borrowing your own money), and you can't take a new 401(k) loan while one remains outstanding.
Five Reasons to Borrow From a 401(k) Plan
When is it a good idea to borrow from a 401(k) plan? Few instances are optimal when your retirement is on the line, but under these conditions, a 401(k) loan could make sense.
1. For Buying a Home
If you've found your dream home, or have uncovered a home purchase deal too good to pass up, a 401(k) loan can land you the down payment needed to close the deal. A 401(k) loan for a new home is especially helpful if your credit score is weak, and a larger down payment is needed to keep interest rates on your home loan down.
2. For Medical Care
If your health care insurance deductible is high and you need $6,000 or $7,000 for surgery or treatment for a serious disease, a 401(k) loan can be manna from heaven.
3. For Getting Out of DebtIf you have $10,000 or even $20,000 in credit card debt, and it's triggering high-interest payments and feeding a low credit score, a 401(k) loan used to fully repay your credit card debt can get you back up on your financial feet again.
4. For Graduate SchoolIf you have an opportunity to further your professional career by attending graduate school, and likely boost your career income in doing so, a 401(k) loan can pay for college, and at a much better interest rate than a pricey student loan.
5. If You Owe Back TaxesIf you find yourself in arrears with the IRS, and owe substantial back taxes, a 401(k) loan can give you a clean slate with Uncle Sam.
Plus, with a 401(k) loan, the process is easy-peasy, it only takes a few days to get the cash, and you don't have to deal with a bank to get a loan. Or undergo that credit check.
Four Reasons Not to Take a 401(k) Loan
There is an abundant risk in taking out a 401(k) loan, and not just because you may not pay the loan back. These 401(k) loan risks are particularly dicey.
1. You'll Miss Out on Investment Growth
When your 401(k) cash is out of the market, it's not working for you and your retirement. If the market moves upward, that's an opportunity missed after you take out a big 401(k) loan.
2. You'll Miss Any Company Matches
Depending on your plan's rules, you might not be able to make contributions until the loan is repaid. This means if your employer has a 401(k) company matching program, you'll miss out on that free money.
3. The IRS Is Watching
If you don't pay the loan back within the agreed-upon repayment timetable, Uncle Sam can play rough. You'll incur a 10% tax penalty and, since the IRS will deem the unpaid 401(k) loan as a plan distribution, the amount will be taxed and you'll owe money on the withdrawal.
4. Changing Jobs Is a Risk
If you switch jobs, there's a good possibility you'll have to repay the loan right away, in full, or face severe non-repayment fines and taxes.
How to Take Out a 401(k) Loan
Once you decide to take out a 401(k) loan, you'll need to follow these steps:
1. Contact 401(k) Plan Sponsor
Procedure-wise, you contact your 401(k) plan sponsor (most companies have a retirement and benefits plan liaison at work, often through human resources) and let them know you want to take out a loan.
2. Check if You Qualify
While many 401(k) plans will allow plan participants to borrow money for any reason, there is no guarantee. Check ahead of time to see if you're cleared for a 401(k) loan. In general, the more dire the cash emergency, the easier it is to get a 401(k) loan.
3. Figure Out How Much Cash You Need
Let your plan sponsor know how much cash you need to borrow from your 401(k) plan. Once the paperwork is cleared, the plan sponsor will direct the investment firm running your 401(k) plan to liquidate your account by the exact amount of the loan request. Due to Wall Street investment trading rules, this process can take a few days, as any trades made to get your 401(k) loan cash have to be settled and cleared in legal and regulatory fashion.
4. Calculate Interest Payments
Figure out how much interest you'll be paying on your loan. The interest may not be much, but you still need to know in advance what you'll be paying. Normally, the interest payable is equal to the current prime lending rate, plus a percentage point or two. Fortunately, the interest you'll pay on the loan is steered right back in to your 401(k) account - a benefit you'll never get with a bank or credit union loan.
5. Come Up With Payment Timetable
Estimate your repayment timetable. By and large, you'll have five years to pay off your 401(k) loan, but there's no rule that says you can't pay it off as early as possible. Often, you'll get longer repayment terms if you're using the money for a down payment on a new house. If you don't repay the loan on time, the IRS can slap you with a 10% penalty. Additionally, the unpaid loan may be considered a cash distribution from your 401(k), and be taxed at current income tax bracket rates.
6. Figure Out Repayment OptionsCheck your loan repayment options. Normally, a 401(k) loan is repaid via paycheck deductions from your employer, after taxes. Ask your employer if there are any other options you should know about, that might work in your favor.
Once you receive the proceeds from your 401(k) loan (usually via a physical check or direct deposit into your bank account,) you're free to use the money as you see fit.
Alternatives to 401(k) Loans
Before you hit "send" on that 401(k) loan deal, consider these "fast cash" alternatives:
- Check your savings options. You could turn to a money market account or even a savings account that's not earning much interest. Taking cash from either savings vehicle is less risk for your long-term financial health. You might also check into an unsecured debt consolidation loan. Such loans tend to carry higher interest rates than a mortgage refinance or home equity loan, and the interest won't be tax deductible, but you'll get your money, as long as your credit is decent.
- Get a low-interest credit card. There is no shortage of credit card providers with great deals on offers, particularly if your previous credit history is solid. Often, you can find APRs of 5% or even less, or even zero percent if you pay off any card debt quickly. That may be preferable to the cash you'd lose by withdrawing your 401(k) funds.
- Borrow from family. You'll likely blanch at doing so, but if mom or dad can bail you out of a serious financial jam without tapping into your 401(k), that's a big win for you. Just make sure all parties agree on the loan and a reasonable payback period, and keep it all in the family.
A Last Resort?
In a big picture sense, borrowing from a 401(k) should be an option of last resort, unless you really need the money.
That's especially the case if you begin to raid your 401(k) on an ongoing basis. In that case, your retirement income is put at risk, and there may be no recovering from too much borrowing from your 401(k) plan.