Financial trouble can happen to anyone. If you’re faced with bills your emergency fund won’t cover, you need an alternative way to get cash in hand. Or you may need a lump sum up front to take advantage of a major opportunity for your family.
You know you want to avoid predatory payday loans. But will you be better off borrowing from your retirement fund, or taking a loan against your home equity?
What is a 401(k) loan?
Many financial professionals emphasize the importance of leaving your retirement accounts alone until you’re retired. While this is sound advice much of the time, there are situations where taking money from your 401(k) can be the right decision.
How does borrowing from my 401(k) work?
The IRS and your employer determine the conditions for a loan. The IRS sets the maximum you can borrow: $50,000, or 50% of your balance, whichever is less. (Saved less than $20,000? You are still allowed to borrow up to $10,000.) Your spouse may need to sign that they agree to the loan.
In most plans, you can access the funds in a few days. Repayment is generally on a 5-year schedule, although often you can pay the loan off faster without incurring prepayment penalties. As long as you pay off the balance in time, you won’t pay taxes or penalties for accessing retirement funds early.
Can I take a loan against my 401(k)?
“Loan” is a bit of a misnomer when it comes to a 401(k). You’re taking money from your own account, so there isn’t really a lender/borrower relationship taking place. That’s why you won’t have to undergo a credit check first, and the loan won’t affect your debt-to-income ratio.
That said, you will follow certain rules that are similar to most loans, like following an amortized payment schedule (i.e., regular, fixed payments) and paying interest as you replenish your 401(k) savings.
Can I use a 401(k) loan to pay off debt?
Most people who consider a 401(k) loan are doing so because they’re in a precarious financial situation. You’re taking money meant for your future and using it to handle a current problem.
If you follow the repayment plan faithfully, and the loan is fairly small, you may not hurt your retirement progress. The interest helps compensate for stock market gains you missed out on in the short term. Meeting the requirements can keep you from having to pay taxes or penalties.
If you use 401(k) funds to pay off current debt and don’t pay the money back, though, the IRS will treat the withdrawal as income. You’ll have to pay taxes on the money you don’t pay back. If you’re younger than 59 ½, you’re looking at penalties for early distribution as well.
The risk of penalties, and the danger of being tempted to borrow from your 401(k) more often, leads many people to look for other avenues to borrow money they need.