If you were to ask financial advisors from top retirement companies, they would probably advise you against borrowing from a 401(k). It would help to avoid getting a retirement plan loan because it reduces your future earnings.
In addition, if you get a 401(k) loan, you have to refund your tax-advantaged account using after-tax earnings. In the end, you will have to work harder to pay back what you owe. In addition, if you leave your job, you have to pay back the remainder you owe, or the employer will consider it a distribution and report it to the IRS. If you are still under 59.5 years, you will have to pay the penalty and taxes owed too.
When to Borrow From a 401(K)
Even though it is not a good idea to borrow from your retirement account, sometimes, it’s the best option you may have. Below are situations that may justify borrowing a loan from your future self.
- If you have financial difficulty and have a bad credit score, which makes it difficult to obtain credit at favorable interest rates, borrowing from a 401(k) makes a lot of sense. That’s because borrowing from the retirement account has zero impact on your credit history.
- It also makes sense to get a loan from your retirement accounts if you have high-interest debts that make it impossible to save money each month. You can use the loan to pay off your creditors. Once your cash flow improves, you can channel as much money as possible into your 401(k) account. Currently, the maximum contribution is $19,500 per year, with an additional catch-up contribution of $6,500 for those 50 years and older.
- If the market is performing poorly and your investments are experiencing low returns, you could borrow money to fund your business. When your company begins to make money, you can pay back the principal and interest. Typically, the interest rate charged for a retirement plan loan is usually one or two percent above the prime rate. And everything you pay back will be yours.
- You can use your 401(k) loan to buy your main home if you don’t have enough money for a down payment.
How to Borrow Money From Your 401(K)
If you are determined to get a 401(k) loan, below are the series of steps you should follow.
- Find out from your 401(k) administrator, senior manager or employer whether you are allowed to borrow from your plan. Not every 401(k) plan allows this kind of loan. And some plans tend to restrict the number of outstanding loans you can have at any one time.
- Determine how much you need to borrow. The general rule of thumb is to borrow up to 50 percent of your vested balance or $50,000, whichever is lower. Don’t borrow more than you need to. Also, ensure you understand the terms of the loan, including the interest rate and repayment methods.
- Come up with a plan to repay your loan. The maximum repayment period is usually five years. However, if you borrow the loan to buy your primary residence, you may be able to get a more extended repayment period of up to 25 years. It is not wise to borrow without knowing how you intend to repay your debt.
- Get your spouse’s consent for the loan you intend to take. That’s usually a requirement for some retirement loans worth over $5,000.
- Apply for a loan. Some administrators allow online applications. Read the fine print before you sign on the dotted line.
- Get your money through your bank account or via a check.
- Use the monies for the purpose for which they were intended.
- Based on your repayment plan, pay off your loan. Try not to default so that the debts don’t become unmanageable. The typical loan requires you to make repayments at least every quarter.
Where possible, avoid borrowing from your retirement accounts like the 401(k). It’s akin to stealing from your future self and can result in unanticipated penalties and taxes if you fail to pay back the loan on time. However, if you have financial difficulties, a bad credit score and high-interest loans, borrowing from your 401(k) could end up being one of the smartest moves you make if you pay back your debts on time.
- The Hartford: Downsides to Borrowing From Your 401(k) to Fund Your Business
- IRS: Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits
- Debt.org: 401(k) Loans: Should You Borrow From Retirement?
- CNBC: There are only 3 situations when it ‘makes sense’ to borrow from your 401(k), experts say
- IRS: Retirement Topics - Plan Loans
- Finra: 401(k) Loans, Hardship Withdrawals and Other Important Considerations
- Forbes Advisor: How To Get A 401(k) Loan
I hold a BS in Computer Science and have been a freelance writer since 2011. When I am not writing, I enjoy reading, watching cooking and lifestyle shows, and fantasizing about world travels.