3 Things You Should Know About 401(k) Loans

First of all, as the Chinese philosophy goes, empty your cup.

Whatever you think you know about 401(k) loans, forget it. There are two sides to the coin that is the 401(k) loan. Each has its own merit.

Among the biggest myths about taking a 401(k) loan is the one that says taking money from your own retirement fund – in essence, robbing yourself.The opposite is often true, but before you jump on the chance for a tax free loan there are 3 things you should know about 401(k) loans.

A 401(k) Loan Isn’t Really a Loan

Loan interest is paid back into your own account and borrowing from yourself means no income tax or 10% early withdrawal penalty – so it’s not a loan in its strictest financial sense, as there is no lender and no assessment of credit rating.

Interest is paid, but technically that is being repaid by you, to you – so it’s actually an increase in your own payments into your retirement plan – provided the cost of taking out the loan is less than the interest. This is usually true.

401(k) Loans Work In the Short Term

A loan from your 401(k) has great terms – up to 50% of the vested balance, up to $50,000 in value. The cost of taking the loan is usually less than $125.

If you need an emergency short term loan and are in stable employment, it makes sense to choose this option over a high interest bank or credit card debit.

The impact of the loan on your retirement savings depends on where you have your 401(k) invested – if the investment is in stocks, then the impact depends on how the market has behaved during the interim of the loan.

The best time for a loan is when the stock market is weakening – which is usually at the onset of recession.

The Cons of a 401(k) Loan

Beware! Late payments on your 401(k) loan will incur steep tax bills. Not paying for 90 days means you lose tax deference and the IRS bill you for tax on the outstanding amount and the 10% withdrawal penalty if you have not reached 59.5 years of age.

If you leave your job or get laid off, the outstanding debt is due immediately and usually with a grace period of only 60 days. Again, failure to pay within the 60 days incurs taxation and a 10% penalty.

Double taxation – repayment is made with money you’ve already paid taxes on so will be taxed again when

While you don’t need to prove yourself to a credit assessor, you can only take out a loan if the reason for the loan fits with the provisions made out by your employer in the terms of your 401(k) plan.

What You Should Learn from This

There are 3 good reasons to take out a loan on your 401(k): Low rates or interest, convenience, peace of mind.

Taking the loan is fast. It can be done online – and you can repay quicker than the typical 5 year loan term with no prepayment penalty.

The cost of defaulting on your loan or late payment is high.

What to do Next

If you are considering a 401(k) loan, first check your alternatives:

can you consolidate debt in other areas (credit cards or other bank loans)?
Is it possible to get a better rate on the loan you already have?

If not, and you feel a 401(k) loan is the only option, find out from your employer if the terms of their 401(k) loans will allow for your circumstances.

Before taking out the loan, create a plan that will allow you to pay it back as fast as possible.     

Take control,

Manny