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Financial Tips

Thinking About Borrowing Against Your 401(k)?

If you have a substantial balance in your 401(k), you may be tempted to borrow against it to pay down credit card debt, medical bills, student loans, or cash advances and payday loans. It sounds like a good idea, yet most financial advisors recommend it as a last resort. What's the catch?

Most 401(k) plans allow you to borrow against the accounts, but not all plans have this option, so check with your plan administrator. Some institutions allow borrowing, but only for a specified purpose such as buying your first home or avoiding an eviction, or paying for education or medical expenses.

To learn the ins and outs about your particular 401(k) account, you may also refer to the Summary Plan Description (SPD) for your 401(k). If your plan is handled through your employer, request a copy from human resources.

The Good

  • 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%.

The Bad

  • You are sidelining your retirement. Taking the money out of a 401(k) means no longer earning money in the stock market. 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. 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 interest 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 401(k) contributions. This further limits your retirement savings. If your employer matches any of your contributions, you would lose income there as well.

The Ugly

  • Repayment requires you to repay the loan in less than five years. 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 early distribution penalties (taxes and fees). Expect the loan will take five years to pay back. So, if you plan on moving, switching careers, or just are worried about job security, this type of loan may not be appropriate for you

Obtaining funds from your 401(k) may help in the short run, but it could be wiser to leave your retirement money to earn investment income. Consider using another 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.

Whenever you face financial difficulties, you have options. Some will benefit you more than others, and each will have advantages and disadvantages. To make an informed and educated decision, consider both the pros and cons.

For no cost, the financial specialists at ClearPoint Credit Counseling Solutions, a national, non-profit organization, will review your financial situation and help you make these types of financial decisions. For a free credit counseling session, call (877) 877-1995 or visit www.credit-counselors.cc.