Borrowing Against a 401(k): What to Consider

Ideally, money that you put into a 401(k) is supposed to stay there until you retire. The IRS imposes a number of restrictions and penalties on early distributions that are meant to dissuade people from pulling their funds out early. Still, the government recognizes that there are times when it’s appropriate to tap into that money, and it allows you to borrow from a 401(k) with some limitations.

How Borrowing Against a 401(k) Works

According to the IRS, if your plan gives you the option to borrow, you can borrow up to 50 percent of the vested amount in your 401(k), as long as the loan doesn’t exceed $50,000. You normally have five years to pay back the loan, although you’ll have a longer time frame if you’re borrowing money to buy a home. You’ll have to make payments on the loan at least four times a year. If you meet those terms, you won’t pay a tax penalty.

However, as Bankrate notes, plans usually require you to pay back the entire loan within 60 days if you leave your job. If you’re not able to pay that, the money will be treated as an early distribution, and you could owe income taxes and a 10 percent penalty.

The Risks of Borrowing From Retirement Funds

One risk is that you could lose your job, not be able to pay back the loan in time and get hit with taxes and penalties. Also, before determining how much you can afford to borrow, take into consideration that when you’re paying back the loan, you’ll be able to afford 401(k) contributions on top of your loan payments. Then you may end up contributing less to your 401(k) during your career. And of course, a downside of borrowing from a 401(k) is that the money you borrow doesn’t earn an investment return for you until you pay it back. The nature of investments and compound earnings is that it’s always better to invest sooner rather than later, so taking money out now and paying it back in the future can lower the amount you have available for retirement.

When Borrowing Against Your Retirement Is the Right Choice

That said, borrowing from a 401(k) is sometimes a good move. An example is when you’re borrowing for an investment, like buying a home. You expect a house you buy to go up in value, so the money is still working for you.

Borrowing from a 401(k) can also make sense for short-term needs, like if you’re waiting for a certificate of deposit to mature and you’ll pay back the loan as soon as it does. In that case, the loan isn’t going to have a large impact on your retirement savings because the money is only out of your account for a short time. And as GOBankingRates reports, the interest rate on a 401(k) loan is typically only 1 percent above the prime rate, so this may not cost you a lot in interest.

And finally, it’s reasonable to borrow from a 401(k) if you need to pay up front for medical treatment, if you need money to avoid falling behind on your mortgage or for other serious needs. You shouldn’t sacrifice your health or safety now just to keep savings intact for later.

Saving for retirement is important, but sometimes other needs have to take priority. When that happens, try to get back on track with contributions as soon as possible to continue building your savings.

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