401(k) Loans-Good or Bad?

If you are in need of cash for an emergency and have a 401(k), it might be tempting to look at your retirement account as a way to pay for the emergency expense. You would probably prefer a loan over a withdrawal and with good reason. The withdrawal would be taxed and penalized but you could take a loan from your 401(k) without either. You would also be paying yourself the interest on the loan and it wouldn’t be going to a bank. Sounds like a win, win? 401(k) loans can be the appropriate tool to utilize in certain situations and have certain advantages but they do have their drawbacks.

Advantages

  • Faster way to get access to up to $50,000 in cash than traditional bank loan.
  • Interest on loan is paid to yourself and not a bank (although this can also be seen as a disadvantage).
  • You do not have to prove a hardship in order to be allowed to take the loan, unlike a hardship withdrawal which may require validation.

Disadvantages

  • Loans usually require payback within 60 days if you leave your job. You don’t need a big debt to show up as soon as you have lost your job.
  • If you can’t pay the balance, the remaining loan is considered a distribution subject to income taxes and possibly the 10% penalty, if you are under age 59.5.
  • While you can continue to contribute to your 401(k) while you pay back your loan, many people don’t because they don’t have the money to make the loan payments and contributions. This may cause you to miss out on matching contributions from your employer.
  • You forego the compounded earnings on the amount borrowed until it is repaid
  • You usually can’t prepay the loan. Either you make the scheduled loan payments or you have to save up the entire amount and pay it off.

Conclusion

401(k) loans can be a very convenient way to access cash in an emergency or for a short-term funding need that can’t be paid for through any other source. However, they do have their disadvantages so careful consideration should be taken before taking a 401(k) loan. Also, it’s very important that you also check with your 401(k) plan custodian to understand their requirements for loans from their plan.

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