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Should You Borrow Money From Your 401(k)?

By Dan Caplinger - Nov 27, 2016 at 12:01PM

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Your 401(k) is a tempting source of funds for a loan, but make sure you know the risks.

Many workers save tens of thousands of dollars in their 401(k) plans over the course of their careers. At certain key times of their lives, however, financial needs can make it tempting to try to tap into this money. Most people understand the shortcomings of cashing in a 401(k), which often include taxes and penalties. However, 401(k) loans can look like better solutions for immediate financial needs. Below, we'll look at the pros and cons of borrowing money from your 401(k).

Why borrowing from a 401(k) can be smart

The most appealing aspect of a 401(k) loan is that it's far easier to actually get the money than it is for most types of loans. If you go to an outside lender for a loan, you'll almost always have to fill out long applications and allow the lender to run a credit check. It can take days or even weeks to have a loan application processed, with no guarantee of successfully getting a loan once the process is complete. With a 401(k) loan, the application process is relatively painless, and you can often get money extremely quickly.

Another advantage of 401(k) loans is in the interest rate that you'll pay. With regular loans, your credit score has a huge influence on how much you'll pay in interest. Rates that are appealing for those with high credit scores can seem usurious for those with less stellar credit. 401(k) loans, on the other hand, treat all workers equally, offering interest rates that are typically tied to some established benchmark. In addition, you're paying interest back to yourself, so you can at least comfort yourself with the idea that no bank is profiting from your need for money.

Finally, 401(k) loans are easy to manage. Typically, your employer will automatically calculate how much you'll need to pay back from every paycheck in order to get the loan paid off within the allowable time frame -- which is five years for most loans and 15 years for loans used for home purchases. You won't have to worry about missing payments, because your HR department will handle withdrawals automatically to go toward repaying your 401(k) loan.

The downsides of 401(k) loans

Even with these positive aspects, 401(k) loans also have disadvantages. The most important one is that a 401(k) loan is tied to your current employer. If you leave your job for whatever reason, then your 401(k) loan will become immediately due, and you'll have an extremely limited period of time in order to pay the loan back even if you still have years left to run on the original loan term. If you don't manage to get the money paid back to your 401(k) account in time, then the outstanding loan balance will be treated as an outright distribution to you. You'll have to pay taxes on the deemed distribution and often penalties as well as a result.

Another downside involves the cost of the loan. When you borrow money from your 401(k), the plan sells your investments to fund the loan. That means you miss out on any income and gains that those investments would have produced over the period of your loan. Meanwhile, even though you're paying interest to yourself on the loan, you're using after-tax money to repay that interest -- but you'll have to pay tax on the repaid interest again when you take ordinary withdrawals in retirement.

Finally, by taking money out of your 401(k) in the form of a loan, you lose the protection against creditors that 401(k) assets have. Once the loan proceeds are in your regular bank account, then creditors can take action against it regardless of the fact that it originally came from your 401(k) account. That can turn what would have been a protected asset into one that your creditors can reach, costing you up to the full amount of the loan.

401(k) loans can give you a lot of financial flexibility, but they also come with traps for the unwary. Make sure you know all the pros and cons of 401(k) loans before you make a decision about whether borrowing from your 401(k) is the right move for you.

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