An available balance in your individual or company-sponsored 401k or other retirement plan can be a tempting solution to pay down credit card debt, medical bills, or cash advances and payday loans. It sounds like a good idea, yet most financial experts say borrowing from your 401k should be a last resort. What’s the catch?
Most retirement plans allow you to borrow against the account, but not all offer this option, so check with your plan administrator. Others will allow loans, but only for a specified purpose such as buying your first home, avoiding an eviction, or paying for education or medical expenses.
To learn the restrictions of your particular account, you should refer to the Summary Plan Description (SPD). This includes 401(k) and 403(b) accounts, so if your plan is handled through your employer you should request a copy from human resources.
• You are borrowing against yourself, so there’s no need for a credit check or minimum credit score.
• You pay your retirement plan back with interest. But as you repay, interest paid on the loan is distributed back into your account.
• Interest rates are usually lower than for commercial loans. Most plans use the prime rate as a base and then add 1% or 2%.
• By borrowing from your 401k, you are sidelining your retirement. Taking the money out of a retirement plan means no longer earning money in the stock market on the amount withdrawn. Your potential gain in stocks is likely to be more than a guaranteed low interest rate.
• There are typically limits on how much you can borrow from your 401k, 403b, or other plan. The thresholds, set by the IRS, generally state that you cannot borrow more than half of your total balance, or $50,000, whichever is less.
• Most programs will only allow one loan to be taken out at a time.
• Payments are often taken directly from your paycheck. You’ll use after-tax dollars to make payments on the loan and you’ll be taxed on that money again when you make withdrawals from the account during retirement.
• If you are married, some plans require written spousal consent.
• Due to their reduced paychecks, most borrowers cannot afford to continue contributions. This further limits your retirement savings. If your employer matches your contributions, you lose the match as well.
• Repayment requires you to repay the loan in less than five years after borrowing from your 401k. The IRS will require you to make equal payments, at least quarterly, over the life of the loan. If these guidelines are not met, the loan may be considered an early distribution (cashing out). Since you cannot take out funds from a 401(k) before the age 59 without paying penalties and taxes, you will usually pay a 10% penalty, plus state and federal taxes.
• If you lose your job for any reason, you will usually be required to repay the entire balance within 60 days or face penalties (taxes and fees). Expect the loan will take five years to pay back. If you plan on moving, switching careers or are worried about job security, this type of loan may not be appropriate for you.
Borrowing from your 401k or other retirement plan to obtain funds may help in the short term, but it could be wiser to leave your retirement money to earn investment income. Consider using other means to address your current financial situation-such as taking out a loan from your financial institution, borrowing from a family member, tapping your home’s equity, or joining a debt management plan.
The certified credit counselors at Clearpoint Credit Counseling Solutions, a national, nonprofit organization, will review your personal situation and help you gain the financial education to make these decisions. For a free credit counseling session, call (877) 877-1995 or visit www.clearpoint.org.