Are 401(k) Loans A Good Idea?

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While it may seem like an easy and convenient thing to do when you are a financial mess, taking a loan out of your 401(k) retirement plan is a serious matter. It seems like a great option since it is your money you are borrowing from and any interest or principal you pay is put back into the account. Of course, as with most things in finance, this option is not a simple as it seems and there are some real points to consider before you decide to get a loan from your account. Essentially, the question is whether 401(k) loans are a good idea in the first place.

The truth is that for most people, a 401(k) loan is not the best option for dealing with a money crisis or an unforeseen expense. Ideally, the money should stay in the account until you reach retirement age since that is the purpose of a 401(k) plan in the first place. As any good financial planner will tell you, you need to have some type of savings this means enough to deal with most situations that might come up that you can access rather than getting into a loan that must be repaid.

If you are still considering taking out a loan, here are the regulations for securing a loan from your 401(k) retirement plan. Now, typically, most 401(k) plan will allow you to take out a loan though there are exceptions. You can borrow up to 50% of your vested account balance or an amount of about $50,000, whichever amount is less. Most loans have a maximum repayment period of five years. An exception to this rule would be if you want to use your 401(k) loan to purchase a home. In that case, you will be allowed a longer payback period.

If the financial situation is dire enough that you have to choose between taking out a loan on your 401(k) or cashing it out, you should just get the loan and pay it back. Don't risk paying a penalty for early withdrawal and become stuck with a tax debt.

Sometimes the best way to get a grasp of the situation and where or not a 401(k) loan is the right move is to weigh the pros and cons. There are some clear advantages and disadvantages associated with borrowing from your retirement account.

Pros:

No loan applications or credit checks. The money is yours. A very low interest rate. This rate is established by the plan and is typically near the prime rate. There are return advantages. The percentage you earn by paying yourself back can be beneficial. You have tax-sheltered interest on the loan. In other words, no taxes will have to be paid on the interest until money is taken from the account. High level of convenience. With some plans, all you have to do is place a telephone call and authorize the loan.

Cons:

An obvious point, you are spending your own money and not borrowing from a lender. With the money taken out in a loan, you are losing the opportunity to earn interest off that money. If the loan isn't repaid, it is considered premature or early distribution so you will end up paying taxes on that money. You would also have to pay the standard 10% penalty. There are no tax advantages, you cannot claim it as tax deduction when you file. Once you've started using the 401(k) for loans, you might develop a habit of it rather than developing a savings balance from which to draw from on the road to retirement years.

In the end, you should really see a 401(k) loan as a last resort. Remember why the account is there: to prepare you for retirement. Respect that and find other means to deal with a financial situation.