If you’re thinking about borrowing from your 401(k), stop and ask yourself if this is a good idea. Before making any decisions, consider the pros — and especially the cons — of taking money from your retirement account.
401(k) loan rules
Borrowing from your 401(k) to pay off debt or cover a financial emergency may seem like the right answer in the short-term: You can access funds quickly, and you may have a shorter and possibly lower-cost repayment cycle than you would with a traditional personal loan, for example. In the long term, though, this move could hurt your finances.
Before tapping into your 401(k), talk to your human resources department to understand the rules of borrowing from your employer’s plan. Most plans allow you to borrow up to 50% of your vested account balance, up to a maximum of $50,000. You will have five years to repay the loan, but you can repay the amount in less time without penalty. Repayment is arranged as a payroll deduction.
If you don’t repay the loan within the repayment period, the IRS will consider the outstanding loan balance to be a distribution. It will then expect payment of ordinary income tax on the amount. If you change jobs or get laid off, there may be a grace period of 60 to 90 days in which you can repay the loan after leaving your employer or the outstanding loan balance will be treated as a distribution..
Furthermore, if you’re younger than age 59½ and fail to repay the loan, you will be assessed a 10% penalty on the amount you borrowed, on top of ordinary income tax. The same is true of loan amounts that aren’t repaid within the maximum five years allowed for the loan term.
Another issue with taking out a loan from your 401(k) plan is that the borrowed amount will no longer grow. You will forgo all earnings and tax-deferred growth on the money borrowed from the 401(k) plan. The loan will be an outstanding liability and will reduce your paycheck, because you’re required to repay the loan through payroll deduction.
Bottom line: Borrowing from your retirement fund has far-reaching implications. Exhaust all other options and resources before borrowing from your 401(k). Members who need help putting together a financial plan can contact their nearest branch to receive no-cost Financial Counseling.
The advice provided is for informational purposes only. Contact a financial advisor for additional guidance.