According to 401k.org, about 20% of Americans eligible for a 401k loan have one, and the average outstanding loan balance is $7,600. Since 401k loans are an option for many, it’s a good idea to familiarize yourself with this tool. Also, keep in mind that not all 401(k) plans allow employees to borrow from their accounts. Check with your human resources department before you even start considering a loan.
The maximum loan amount allowed is restricted to one-half of the purchased account balance or $50,000, whichever is less. While interest rates vary by plan, the most common rate is the prime rate plus one percent. Unless the borrowed funds are used to purchase a home, most 401k loans must be paid in full within five years.
The advantages:
- Loans are not subject to income tax or early withdrawal penalties (unless the loan defaults).
- Loans are convenient. There is no credit check or long application form.
- The loans have low interest rates. Most 401k loans are cheaper than credit card fees.
- The interest paid on the loan is paid to you, not to a bank or other lender.
The disadvantages:
- The borrowed money will not be invested in the market, so any potential investment gains will be lost.
- Borrowed funds will be taxed twice! Borrowers earn wages, pay taxes on those wages, and use those after-tax funds to repay the loan. During retirement, the retiree will again pay taxes on the withdrawn funds. Consider an investor who is in the 25% federal tax bracket: paying twice the tax would be extremely expensive.
- Investors with a 401k loan ultimately contribute less to their retirement plan because a portion of the new contributions will go toward paying off the loan.
- If you leave your current employer, your entire loan is usually due within 60 days. If you are unable to repay the loan, you are considered in default and will be taxed on the outstanding amount and will be subject to a 10% early withdrawal penalty if you are under age 59½.
In general, I believe a 401(k) loan should be considered only if it is essential and all other financial resources have been exhausted. However, there are cases where a 401(k) loan can be a fantastic solution. For example, I have a client who expects to receive an inheritance in the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from their 401(k) plan to cover the initial cost of the mortgage loan and pay the loan back in full once the inheritance is received. This allows this person to borrow funds cheaply but without losing the great benefits that his retirement plan provides.