Borrowing from 401(k) is the most attractive and widely practiced way of raising liquid cash at the time of need. Why is it so popular? Because it is perceived as the quickest, simplest and cheapest way to raise money and therefore people find it attractive and consider it as the ultimate choice to meet their financial needs.
Technically speaking 401(k) loan is not a loan at all in its usual sense. Because, there is no lender in this scenario. You are just borrowing money from yourself, which has been put aside for some reason (i.e., retirement) for some other reason (i.e., emergency requirement).
Before considering taking loan on 401(k), it’s good to know the rules and financial implications of such action. Employees can borrow up to 50% of their account balance or $50,000 whichever is less. The borrowings should be paid back within 5 years; but if the money is borrowed to purchase the primary residence, then the loan tenure can be stretched to 10 or 15 years. If the employee loses his job or terminates his service with the employer, then this loan is payable within 60 days; otherwise it will be considered as withdrawal and subject to tax and penalty, if any.
Using your 401(k) savings as piggy bank is not at all good idea. But in some extremely difficult financial situations it may be required to tap into your savings. Borrowing from your 401(k) plan has certain merits as well as demerits.
Merits of borrowing from 401(k) plan
- It is less expensive – Comparatively 401(k) loan is less expensive than other commercial loans and it does not involve any extra cost to obtain the loan.
- Easy and convenient – Borrowing from 401(k) is easy and convenient method of raising funds at the time of your needs. It does not require lengthy paperwork; and it neither involves checking your credit history nor affects your credit rating.
- Easy repayment – Loan repayment can be done easily through payroll deductions. Moreover, you are paying yourself back with interest.
Demerits of borrowing from 401(k) plan
- Reduces your savings – 401(k) savings is meant for retirement and if you take the money from it, it curbs your retirement savings to that extent.
- Extra tax payment – Loan repayment is done with after tax money and the interest is not tax deductible. Further, you have to pay the tax again while making your withdrawals later.
- Attract penalty – If you are unable to repay the loan within the stipulated period then it will be considered as withdrawal. Such withdrawal will be subject to tax as well as 10% early withdrawal penalty if your age is below 59 ½.
- Lost time value – Uninterrupted contributions will grow into a big amount because of magic of compounding. Withdrawal in the middle curbs the growth and thereby reduces the size of final amount.
- Opportunity cost – If you lose your job (or change the job), most employers require you to make the full payment of your loan within 60 days. Further, this outstanding loan may force you to stick with your present job and stop you from exploring the new opportunities that offer career growth and increase in income with a new employer.
- Living beyond your means – The need to borrow from your 401(k) indicates that you are living beyond your means. It’s not advisable to dip your hands into your retirement savings to finance your present requirement. It may put you into an extremely difficult situation during later stage of your life.
Borrowing from your 401(k) should be done only under extremely difficult situations. Saving for your retired life is non-negotiable and it is not preferable to use your future money to meet your present expenses. Think twice before dipping your hands in 401(k) funds. Don’t live beyond your means; and remember that 401(k) is an investment vehicle and never treat it as an emergency fund to meet your indulgences.