If money is tight, you may have considered drawing from your 401(k) retirement savings plan. While it’s generally best to leave your investments intact, there are circumstances in which tapping into your account can be a safer move than obtaining other kinds of loans. Here’s a look at a few factors to consider before you commit to borrowing money:
Understanding 401(k) loans
A 401(k) loan is different from other types of loans since you’re borrowing from your own retirement fund. Therefore, you won’t have to undergo any credit checks or deal with a negative impact on your credit score. Furthermore, the money taken from your 401(k) isn’t taxable, as long as you abide by the terms and conditions of the loan agreement. According to Troy Segal, a contributor to Investopedia, if you can’t pay it back on time, the unpaid money will be counted as a distribution and therefore be taxed.
There are also limitations on how much money you can receive. You can access up to $50,000 from your savings, or up to 50 percent of its value — whichever figure is lower. However, according to Segal, you may be able to receive a longer repayment period if you use the money to buy a primary residence. The length of the term will be at the discretion of your plan provider.
If you’re seriously short on cash, pulling from your 401(k) may be one of your safer options. According to Kathryn B. Hauer, MBA, CFP, this type of loan is less risky than other short-term ways to get cash, like payday loans, title loans, and even personal loans, which often carry high interest rates. But if you manage the loan properly and pay it back on time, your total savings may not take that much of an impact.
In terms of interest, a 401(k) loan has several advantages over other types of loans. When borrowing from your investments, you’ll be charged a small administration fee to get started, but the interest on the loan will go back into your account. This interest fee is charged to help you make up for any investment interest earnings you would have received if the money was never lent from your account. Therefore, when the market is weak, you’ll receive a low interest rate.
A retirement fund loan comes with certain disadvantages. First off, not all 401(k) programs allow you to take out a loan. According to BrightScope, a retirement data aggregator, only about 80 percent of 401(k) plans allow you to tap from them. Therefore, make sure your plan allows lending before you count on it as a potential source of emergency cash. And if you have an account from a previous employer, you can’t draw upon those funds for a loan, unless you’ve shifted your investments over to the account your current employer is providing.
There may also be circumstances in which you have to pay the money back more quickly. If you leave or lose your employment, you won’t have the full five years to pay off the loan. According to James Royal, if you are no longer employed by the plan provider and have a loan on that account, you’ll have to pay it by the same as the day that your next tax return is due. This can put you in quite a crunch if your employment situation isn’t stable.
Think of your unique situation before deciding which kind of loan is right for you. If you’re considering taking out a 401(k) loan, consider consulting with a financial advisor to weigh your options.