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Should You Borrow from Your 401K?

Seth Jentner09/04/2013

I’m often asked: Is it ok to borrow money from your 401(k) plan to cover other financial needs?

Almost a quarter of employees who have 401(k) retirement savings accounts are using them as piggy banks. However, the potential retirement and tax booby-traps may not be so evident.

Let’s first acknowledge that there are situations where a family faces an unexpected and overwhelming need for cash that must be met. If there are no other resources available, borrowing from one’s 401(k) plan is generally superior to withdrawing the money. If withdrawn, the funds would be subject to income taxation and would no longer be available for retirement.

401(k) participants can borrow up to one-half of the value of their accounts, to a maximum of $50,000, and avoid taxation of the amount borrowed if repaid on a timely basis.

Recognizing this, it’s generally a good idea to avoid borrowing from your 401(k) plan if you can. Here are three reasons why:

  1. Borrowers are hit by a double taxation of the loan interest proceeds. Your 401(k) loan interest payments are made with after-tax dollars and then get taxed again when you withdraw them in retirement.
  2. Borrowers may hurt their overall investment returns. They are required to pay interest on their loans, usually at the prime rate. But since that rate currently is at 3.25%, employees will get modest returns on their accounts while repaying the loan.
  3. Borrowers can also get hit by unexpected taxes and penalties if they lose their job while the loan is outstanding. If an employee leaves or loses a job while repaying a loan, the loan usually will come due. If the employee can’t repay the entire amount, he or she will owe taxes on the balance, as well as a 10% early-withdrawal penalty if he or she is younger than 59.5 years of age.

Consider a 401(k) loan as a loan of last resort. For most people, it’s difficult to put money aside for retirement. Once you put it aside, you do not want to jeopardize it before your retirement. While a 401(k) loan has some benefits, a loan should be avoided unless facing a genuine financial emergency.

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