A 401(k) is where many Americans build their retirement nest egg, and that of course is the primary function of a 401(k) account. But in a financial emergency, you may be able to tap into your 401(k) plan assets in the form of a loan. While taking a loan may help solve an immediate financial need, there can be consequences that may reduce your long-term financial security.
Here's what you need to know.
First, not all 401(k)s permit you to take out a loan, but many do. Check with your company's human resources department to find out what is possible.
When you borrow from your 401(k), it's like getting a loan from any financial institution. You sign a loan agreement that spells out the principal, the terms of the loan, the interest rate, any fees, and other conditions that may apply. You may have to wait for the loan to be approved, though in most cases you'll qualify -- after all, you're borrowing your own money.
Even so, you must pay a market interest rate. This means the rate must be comparable to what a conventional lender, like a bank, would charge on a similar-sized personal loan.
Also be aware that you typically can't borrow all the money you have in your 401(k). That's because the IRS limits the maximum amount you can borrow to the lesser of $50,000 or 50% of the amount you have vested in the plan -- unless 50% of your vested account balance amounts to less than $10,000. If your employer's plan includes this exception (plans aren't required to do so) and the exception applies in your case, then you may be able to borrow up to $10,000. In some plans, you must borrow at least a minimum amount of money, which is called the "loan floor."
Usually, 401(k) loans have a five-year term. That's the longest repayment period the government allows. However, if you prefer a shorter term, you may be able to arrange it. The only exception is if you use the loan proceeds to buy a primary residence -- the home you'll be living in full-time. In that case, some 401(k) plans allow you to borrow for 25 years.
And when it comes to paying off the loan, most 401(k) plans require you to repay your loan through payroll deductions, which means you're unlikely to fall behind as long as you remain employed.
So what happens to your 401(k) investments when you take out a loan? It depends -- and be sure to ask. The money usually comes out of your 401(k) account balance. In many plans, the money is taken in equal portions from each of the different investments you hold. For instance, if you have money in four mutual funds, then 25% of the loan total comes from each fund.
In other 401(k) plans, you may be able to designate which investments you'd prefer to tap to put together the total loan amount.
Pros and cons of 401(k) loans
Before you make the decision to borrow from your 401(k) account, consider the following advantages and drawbacks.
On the plus side:
- You usually don't have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you pay is paid into your 401(k), so you're repaying yourself.
- There is no income tax or potential early withdrawal penalty, as you're borrowing rather than withdrawing the money.
On the negative side:
- The money you withdraw will not grow if it's not invested.
- You repay the loan with after-tax dollars that will be taxed again when you eventually withdraw them from your 401(k).
- The fees you pay to arrange the loan may be higher than on a conventional loan, which depends on the way they are calculated.
- The interest on the loan is not deductible, even if you use the money to buy or renovate your home.
Beware of the risks
Likely the biggest risk you face with a 401(k) loan is leaving your job while you have an outstanding loan balance. If that's the case, you'll probably have to repay the entire balance within 90 days of leaving. If you don't repay it, you'll be in default, and the remaining loan balance is considered a withdrawal. You'll also owe income tax on the full amount. So you could find your retirement savings substantially drained.
For more information on managing and investing in a 401(k) account, visit FINRA's 401(k) Learning Center. To learn more about retirement savings and income, visit the Investors section of FINRA.org. You can also subscribe to FINRA's Investor News newsletter.