Smart 401(k) Investing—Special Features of Your 401(k)

Borrowing From Your 401(k)

 

You may be able to tap into your 401(k) plan assets during a financial emergency. But while taking a loan or a hardship withdrawal may help solve an immediate need, there can be consequences that may reduce your long-term security.

 

401(k) Loans

 

If you need cash, you may be tempted to borrow from your 401(k) rather than applying to a bank or other lender. While not all plans permit loans, many do. And with most plans, you repay your loan through payroll deductions so you're unlikely to fall behind as long as you remain employed.

 

When you borrow from your 401(k), you sign a loan agreement that spells out the principal, the term of the loan, the interest rate, any fees and other terms that may apply. You may also have to wait for the loan to be approved, though in most cases you’ll qualify. After all, you’re borrowing your own money.

 

Federal law caps the amount you can borrow at the lesser of $50,000 or half the amount you have vested in the plan. Sometimes there’s a loan floor, or minimum amount you must borrow. The law also requires that you pay market interest rates. That means the rate must be comparable to what a conventional lender would charge on a similar-sized personal loan.

 

Normally, the term of a 401(k) loan is five years. That’s the longest repayment period the government allows—though if you prefer a shorter term, you may be able to arrange it. The only exception occurs if you’re using the money to buy a primary residence—the home where you’ll be living full time. In that case, some plans allow you to borrow for 25 years.

 

Spousal Stamp of Approval

If you’re married, your plan may require your spouse to agree in writing to a loan. This is because a spouse may have the right to a portion of your retirement assets if you divorce. If you borrow, change jobs and don’t repay, that money may be gone, and your spouse’s share may be affected.

 

Coming Out . . . Going In

 

When you borrow from your 401(k), the money usually comes out of your account balance. In many plans, the money is taken in equal portions from each of the different investments. So, for example, if you have money in four mutual funds, 25 percent of the loan total comes from each of the funds. In other plans, you may be able to designate which investments you’d prefer to tap to put together the total amount.

 

The advantage of being able to choose is that you can leave the investments providing the strongest performance untouched, provided that you have enough money in other plan investments to equal the amount you want to borrow. Of course, since there is no way to predict market performance, you might choose to take money from poorly performing stock funds only to find that those funds were about to regain their strength. Then, having suffered losses, you would also miss out on gains.

 

Weighing Pros and Cons

 

There are several advantages and some potential drawbacks in borrowing from your 401(k) account.

 

On the plus side:

  • You usually don’t have to explain why you need the money or how you intend to spend it.
  • You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
  • The interest you repay is paid back into your account.
  • Since you’re borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.

 

On the negative side:

  • The money you withdraw will not grow if it isn’t invested.
  • Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
  • The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
  • The interest is never deductible even if you use the money to buy or renovate your home.

 

Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If that’s the case, you’ll probably have to repay the entire balance within 90 days of your departure.

 

If you don’t repay, you’re in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if you’re younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.

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