401(k) Loan - Should
You Ever Take One? Pros and Cons of Borrowing from 401k Plans
(June 29th, 2009)
may sometimes find yourself in temporary financial hardship where
expenses have sprung up such as a large medical bill, phone bill,
college expense, etc and you need to immediately borrow a loan.
Your options include credit card, personal loan from the bank or
a 401k loan. Afterall, the money in your 401k plan is all yours,
so why do you need the permission to borrow? Financial experts however
advise to stay away from borrowing 401k loans as much as you can.
In this article, we explore the pros and
cons of borrowing from 401k plans and you can then decide for yourself
whether it is worth borrowing or not.
Pros of Borrowing from 401(k) Plans
The most distinct advantage of borrowing
from 401k plans is that there is no application form to fill out,
no credit check, no visit to the bank, etc thus making 401k loans
a very easy process. The IRS allows you to borrow a maximum of $50,000
or 50% of your funds, whichever is lesser. The amount you borrow
must be paid back in 5 years. Also note that you are allowed to
borrow more if you are planning to buy a house and use your 401k
funds as down payment. The interest rate charged is the normal bank
prime rate + 1-2%. Also note that in 401k loans, you are the lender
and the borrower. Thus, the interest payments that you are making
are being added to your original 401k balance, thus helping you
grow your funds.
Cons of Borrowing from 401(k) Plans
The cons of borrowing from your 401(k)
are that once you withdraw money, you are no longer in the tax shelter
protection. The interest that you pay yourself on the 401k loan
is taxable by the IRS and this eats in to your return. Financial
experts think investors who take out 401k loans and pay taxes on
the interest payments they make to themselves would be better off
investing in stocks, mutual funds or bonds. A major risk of borrowing
401k loans is that if you do borrow a loan and then quit or lose
your job, you will have to pay back the entire loan amount within
60 days. If you do not repay the loan in 60 days, you will be charged
a 10% penalty on the balance of funds if you are 59 and 1/2 years
or lesser. Furthermore, you will have to pay your local state taxes
as well as Federal taxes as the loan will be considered a premature
401k withdrawal and not a loan.
Also note that some organizations do not
allow you to make 401k contributions while you have a loan outstanding,
thus eating in to your long term returns on investment and the total
nest egg you will have upon retirement. Also, other companies will
automatically deduct 401k loan repayments from your bi-weekly pay
check thus making it convenient for your repayments, but not allowing
you the flexibility or timing of payments.
Alternatives to a 401(k) Loan
The best alternative to a 401(k) loan is
tapping in to your home equity line of credit. If you own a home,
your bank can give you $50,000+ cash while keeping your home as
collateral, with very low interest rates. In fact, the interest
rate offered on a line of credit is less than the interest on a
401k loan. Also, home equity lines of credit offer flexible repayment
schedules, talk to your bank about repayment options.