Sometimes we need some extra cash to make ends meet or to pay for some unexpected expenses. Increasingly, people are borrowing money - from themselves.

401(k) Loans

Many US workers have a 401(k) retirement account. In general, they let workers put some of their pre-tax wages into a special account and invest it. Employers usually match their employees' contributions, too. The idea is to grow your money and build a retirement nest egg over time.

In August 2010, more and more workers are tapping into their 401(k)'s - long before they retire. Why? Many are doing it to help make ends meet at home. Many employers are cutting wages, overtime, and the number of hours employees may work, all of which means less take-home pay.

Other reasons why you may be looking into a 401(k) loan may be to pay some medical expenses, make a down payment on a new home, or pay college tuition for your child. Regardless of the reason, you should know how these loans work and some pros and cons of taking one.

General Rules

Each 401(k) plan has its own rules, but here are some rules you're likely to see:

  • Time. In most cases you can choose to repay the loan over a period of 1 to 5 years. However, if you're taking the loan to help buy your main home, you may be able to repay over 15 years
  • How much? Usually, you have to borrow at least $1,000 and you can't borrow more than 50% of the balance in the account or $50,000, whichever is lower
  • Fees. You'll likely be charged a fee for the costs of processing the loan, probably somewhere between $50-$100. The fee is taken from your account, it's non-refundable, and it's not included in the amount of the loan, so you don't recover the fee - it's gone
  • Repayment. Payments are taken directly from your paycheck

Contact the administrator of your 401(k) plan for the specifics of your plan before you make the loan.

Pros and Cons

Is it a good idea to borrow from your 401(k)? Take a look at some the advantages and disadvantages.

Pros

On the plus side:

  • It's an easy process. Usually, you can arrange a loan over the telephone or online. Some plans require you to fill out a short form. And, in most cases, you get the money within five to seven business days
  • You get a low interest rate, usually only a percentage point or two above the prime rate and usually far less than a regular bank loan
  • The money you pay back, including interest, goes into your 401(k). So, it's possible you'll make more money by taking the loan than by letting the money sit in the account
  • You'll get the loan even if you have terrible credit. You're borrowing your own money, after all

Sounds good so far, doesn't it? Now, consider the downside:

  • The maximum 5-year repayment period is short when compared to regular bank loans
  • Your paycheck will be smaller - maybe much smaller, depending on the amount of the loan
  • You may not be able to pay into the plan until the loan is paid off, which also means you're losing the free money your employer would normally contribute to your account
  • The money you borrowed isn't getting any of the benefits the remaining 401(k) money gets, such as interest or payment on dividends. So, you may lose money by taking the loan
  • If you don't repay the loan, the amount you borrowed will be considered an early withdrawal. That means you have to pay taxes on it (it's added to your income) and you have to pay a 10% penalty if you're under 59 1/2 years old

Alternatives

There may be some options available to you that may be better than taking a 401(k) loan, such as:

  • Home equity loans or lines of credit. The amount available is based upon the difference between the current value of the home and the amount you still owe. You get longer repayment periods than a 401(k) loan, and, usually, the interest is tax deductible
  • Use money sitting in a regular savings or checking account. The odds are, that money is making much less in interest than your 401(k)
  • If your loan is for college tuition, look into financial aid and talk to the school about scholarships
  • Ask a family member or friend for a loan. You'll likely get a better interest rate and some leniency on how long you have to repay

Tough economic times and everyday expenses affect practically everyone. When trying to stay afloat or dig out of a financial hole, it's important to research and consider all of your options. This way, you make the best decision possible without making today's bad financial condition last for years into the future.

Questions for Your Attorney

  • Does my employer have any say in whether I can borrow from my 401(k)?
  • What happens if I'm laid-off and I still owe on a 401(k) loan?
  • Can a plan administrator require me to give a reason for why I want to take a 401(k) loan?

Tagged as: Employee Benefits, Labor Employment Law, 401k loan, employee benefits lawyer