Your retirement accounts are meant for saving and investing money instead of borrowing it. However, if you find yourself in a situation where you need to borrow money and have few options, a 401(k) loan may be helpful for your situation.
A 401(k) is an employer-sponsored retirement plan that allows you to make pre-tax contributions. There are penalties for withdrawing money from your account before 59 ?, but you can borrow some of your 401(k) money if you’re able to follow a few specific rules.
A 401(k) loan is exactly what it sounds like – borrowing from your own 401(k) account and paying yourself back over time. However, a 401(k) loan isn’t a true loan since there’s no lender or credit score evaluation. Your 401(k) company ounts, but the IRS limits how much you can borrow to whichever is less: $50,000 or 50% of you vested 401(k) balance.
You do, however, have to pay origination fees and interest – you’ll just pay this back to yourself. To borrow money from your 401(k), you’d need to ask your employer about their 401(k) loan options and fill out the necessary paperwork.
Quick tip: Borrowing from a retirement account always comes with the risk of missing out on growth and compound interest . An alternative would be to consider getting a personal loan if your credit is good or try a 0% APR credit card for smaller expenses.
“The interest rate on 401(k) loans tends to be relatively low, perhaps one or two points above the prime rate , which is less than [what] many consumers would pay for a personal loan,” says Arvind Ven, CEO of Capital V Group located in California. “Also, unlike a traditional loan, the interest doesn’t go to the bank or another commercial lender, it goes to you.”
Ven also warns that if you’re unable to repay your 401(k) loan, the brokerage company managing your 401(k) will report it to the IRS on Form 1099-R.
“By then, it’s treated as a distribution which includes more fees, so it’s important to keep up with payments and stay on track.”
Quick Tip: The IRA requires 401(k) loan payments to be made at least quarterly to avoid classifying the loan balance as a distribution. Even if you’re falling behind with payments, you should aim to pay something on your 401(k) loan and communicate with the brokerage so you can get back on track and avoid paying taxes and penalties.
There are some people who might say that getting a 401(k) loan is a good idea while others would disagree. This is why it’s important to compare the pros and cons so you can make the best decision for your situation.