With the state of the economy, a 401(k) loan has become an increasingly attractive source of funds for some people. If you’re considering this option, here are some things you should know:
- There are limits. You’ll have restrictions both on how much you can borrow, and on how long you’ll have to pay the money back. Generally, you can borrow up to half of your account balance, or $50,000, whichever is less. And, you usually have to pay the loan back within 5 years, with payments –which are automatically deducted from your paycheck in the form of after-tax dollars – starting in the pay period after you take the loan.
- There’s no credit check. You’re essentially making a loan to yourself, and since there’s no bank or other institution involved, there’s no credit check.
- You pay yourself the interest. Because you’re making a loan to yourself, the loan payments, and the interest you’ll pay on the loan, go back into your 401(k) account.
- There’s significant risk. If you leave your job – or you’re terminated – your loan is generally due in full within 60 days. What happens if you can’t repay it? If you’re under age 59 ½, then the amount left outstanding is considered an early distribution from your retirement account, and you’re on the hook not only for income taxes on the funds, but also for a 10% penalty.
When you borrow money from your 401(k), you’re losing out on the potential growth that the borrowed money represents for your retirement account. Plus, because you pay back the loan with after-tax dollars, and then you’re taxed again when you withdraw money from your account from retirement, a 401(k) loan results in an income tax double-whammy.
All of this means that a 401(k) loan should only be used as a last resort during a true financial emergency.