While you may be struggling to make it financially, and are looking for help anywhere you can, there are a number of things that you need to consider before deciding to take a loan from your 401(k).
In many ways your 401(k) may seem like the super hero of financial assets that can do pretty much everything except leap buildings. It helps you utilize tax-deferred earnings and traditional ones can even help you make contributions that can reduce the amount of income that you have to claim on your tax return. You can even take advantage of a whole host of investments that are made available thanks to your unique plan.
The biggest upside of your 401(k) plan may be the fact that you can actually borrow money from it, but that is not a decision that you should ever take lightly or before ensuring that you’ve completed all the research.
Read the Fine Print and Learn the Rules
At the moment, the IRS allows people to borrow as much as half of the money invested in their plan, up to a total amount of $50,000. Of course, there are other restrictions, minimums, and calculations that make the process unique for each and every person.
Before you can decide whether you want to borrow money from your plan, you need to know how a normal 401 (k) loan actually works.
The sponsor for your plan, your employer, sells a portion of your investment in the plan in an equal amount to your loan. For example, if you have a plan that has 60% invested in a mutual fund and 40% invested in a mutual fund that is fixed-income everything will be sold in the same way. Each subsequent loan payment that you make will be reinvested in much the same manner.
Any money that you borrow from the plan will usually need to be repaid before the end of five years, although there are exceptions. For instance you can secure a loan for a longer period of time if you are trying to purchase a place of residence. Your employer will need to negotiate the specific details and terms, while the IRS demands that payments be made quarterly, at least, in order to ensure the repayment.
The Benefits of Borrowing
One of the main benefits that come with a 401(k) loan is the fact that it is very private when compared to loans from a traditional lending institution such as a bank. The entire process is also quite simple, which intrigues many people who are looking to stabilize their finances. Add onto that, the fact that there is a very little chance you will be turned down, and it is easy to see why this type of loan is far more comfortable and convenient than other options that might be available.
On top of this comfort, these types of loans can also offer competitive rates that hover right around the revolving prime rate. However, while home equity loans give you the opportunity to deduct interest, a 401(k) loan does not. Yet the interest that you pay on the loan actually goes back into your account which helps your plan grow and does help you out in the long term.
The Drawbacks of Borrowing
While on the surface a 401(k) loan can seem to be full of bonuses, you need to make sure you understand all the other potential costs that come along with it, such as losing out on the amount you can tax-defer.
The overall effect of your loan on your retirement plan will have a lot to do with how much you borrow and how quickly you are able to pay it back. If you can repay the loan within a few months, or within a year or two, then there will not be much of an effect on your long term financial security. Better yet, if you can continue to contribute to the plan while you are paying back the loan, there will be little to no adverse effect down the road.
However, this type of loan can be quite detrimental if you end up leaving your company before you have had the opportunity to pay it back in full. Once you have left your job, or stop contributing, the amount you have not paid back becomes taxable and ensures that you lose your opportunity for investment gains. On top of that, even if you stay with your employer there is a change that your 401(k) loan interest rate may be higher than the return of your investment, which can really put a damper on your overall retirement fund.
In the End…
The main reason that anyone invests in something such as a 401(k) plan is as a means for long term financial success. The sooner you begin, and the longer you can leave your money invested, the better off you will be when retirement actually comes along.
On the other hand, if you have built up a substantial investment and are searching for financial help to keep you above water, your plan could be the perfect place to turn. Just make sure that you read all of the rules, discuss all the options with your employer, and be positive that you will be able to pay back the loan as soon as possible.
The last thing you need is to borrow money on a whim for that brand new car, and end up leaving yourself up the creek without a paddle when it comes to your retirement.