The dos and don'ts of life are rarely black and white. What's right for one person may not be right for another. That's certainly the case with borrowing from a 401(k). Ideally, no one would ever need to borrow from their retirement account, but that's not realistic. Here, we look at three reasons a person may turn to their 401(k) for funds and four reasons to avoid disturbing the account, if at all possible.
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When borrowing from your 401(k) could make sense
Life can sometimes get messy, and quick access to money may seem like the only way out. Here are three scenarios in which borrowing from a 401(k) could make sense.
- Urgent need: If a loan is necessary to meet an immediate financial need, it could make sense.
- Credit issues: When there's an emergency and your credit score makes it difficult to qualify for an affordable loan elsewhere, your 401(k) could be your best bet.
- Interest rates are high: Let's say you have a large unexpected expense during a period of exceptionally high interest rates. If borrowing the money is essential for your living situation, it might pay to check the current rate on a 401(k) loan.
As reasonable as each of these reasons may be, it's a good idea to consider all your options before borrowing the money. For example, if you have a short-term problem, such as needing to replace your vehicle's brakes, there may be better options available than a 401(k) loan, like asking your bank or credit union for a short-term loan. Even if your credit score isn't quite up to snuff, a financial institution you already work with may be willing to overlook it for a short-term loan lasting only a few months. This is especially true for members of credit unions.
For a short-term financial issue, you may also want to consider paying with a credit card and repaying it as quickly as possible to minimize interest charges.
When borrowing from your 401(k) is a terrible idea
There are some pretty solid reasons to avoid a 401(k) loan if possible. Here are four of them:
- When your job isn't stable: None of us knows for sure what's going to happen in the upcoming weeks and months, but if you have any sense that your job may not be secure, now is a bad time to consider a 401(k) loan. That's because if you leave your job, you'll be required to repay the loan quickly, often within 90 days.
- If you suspect you'll have difficulty repaying the loan: If you're under 59½, you're subject to both income tax and a 10% early withdrawal penalty on an unpaid 401(k) loan. If you're in a financial bind and concerned you may have trouble repaying the loan, avoid digging a deeper hole for yourself.
- When you're not willing to face double taxation: A 401(k) loan is repaid with earnings you've already paid taxes on. However, during retirement, you're going to pay taxes on those withdrawals. In a nutshell, you'll be paying taxes twice.
- When the loan is a result of something you want, but can live without: Let's say you love classic cars and have always wanted one. You're at a car auction with a friend and see the vehicle of your dreams. Borrowing money from your future to pay for something you want (but can live without) could be a big mistake, as it means missing out on the potential growth of your 401(k) funds.
IRS regulations
According to the IRS, a qualified 401(k) plan is not required to provide loans. And if it does, the plan may limit how much can be borrowed. The maximum loan amount of a plan that permits loans is either:
- 50% of your vested account balance, or
- $50,000, whichever is less
There is an exception to this limit. If 50% of your vested account balance is less than $10,000, you may borrow up to $10,000.
Although you can have more than one outstanding loan from a plan at the same time, the outstanding balance of all loans cannot exceed the plan's maximum amount. Let's say the plan's maximum loan amount is $50,000, and you already have a loan of $30,000. That means the most you could borrow is another $20,000.
If you must borrow from your retirement account, your first step is to determine if your plan allows loans. Next, learn everything you can about how much interest you'll pay on the loan, how quickly it must be repaid, and what happens if your company conducts a layoff or goes out of business before you've had time to repay.
Life happens, and it's easy to understand how tempting it can be to borrow money you've already saved. However, before you do, consider all your options and make sure a 401(k) loan is the right move for you.
