Taking money out of a 401(k) might seem like a straightforward solution when you need funds, but it’s crucial to understand the implications, especially when considering a 401(k) loan. A 401(k) loan allows you to borrow money directly from your retirement savings account. The amount you can borrow typically depends on your vested account balance and your employer’s plan rules. Generally, you can take out up to 50% of your vested balance, with a maximum of $50,000. However, if 50% of your vested balance is less than $10,000, you might be allowed to borrow up to $10,000.
It’s important to remember that a 401(k) loan isn’t free money; it’s a loan that you must repay, with interest, usually within five years. Your specific 401(k) plan will outline the exact terms, including the maximum number of outstanding loans you can have and whether spousal consent is needed.
The Upsides of 401(k) Loans
One of the primary advantages of opting for a 401(k) loan when taking money out of your retirement savings is avoiding immediate taxes and penalties. Unlike direct 401(k) withdrawals, loans are not considered taxable events. Furthermore, the interest you pay on the loan isn’t going to a bank; it’s paid back into your own 401(k) account, essentially benefiting yourself. Another potential benefit is that defaulting on a 401(k) loan doesn’t negatively affect your credit score, as these defaults are not reported to credit agencies.
The Downsides of 401(k) Loans
Despite the advantages, there are significant drawbacks to consider before taking money out of your 401(k) through a loan. A major concern is the repayment timeline if you leave your current job. Often, your plan requires you to repay the loan in full shortly after leaving employment. If you can’t repay, the outstanding loan balance is treated as a distribution, making it subject to both income taxes and a 10% penalty if you are under 59½. Perhaps the most significant hidden cost is the lost investment growth. The money you borrow isn’t growing tax-deferred within your 401(k), potentially missing out on market gains that could exceed the interest you’re paying back to yourself.
Making an Informed Decision
Taking money out of your 401(k), even as a loan, should not be taken lightly. While 401(k) loans offer a way to access funds without immediate tax penalties and allow you to pay interest back to yourself, they come with risks, particularly concerning job changes and lost investment opportunities. Carefully consider your financial situation and explore all alternatives before deciding if a 401(k) loan is the right choice for you.
