2646: 401(k) Loans: What Are Their Pros and Cons? by Amanda of Women Who Money on Financial Planning

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[00:01:21] episode 2646, 401K Loans. What Are There Pros and Cons? by Amanda of womenwhomoney.com.

[00:01:30] And I'm your host and personal finance enthusiast, Diana Merriam. Now let's get right to it and

[00:01:36] continue optimizing your life. 401K Loans. What Are There Pros and Cons? by Amanda of womenwhomoney.com.

[00:01:50] If you contribute to a 401K plan through your employer, it could be one of your most

[00:01:54] substantial assets beside your home. And if money is tight and your savings account balance

[00:01:59] is running low, you might wonder how you can tap the funds in your 401K for a loan.

[00:02:04] But you suspect there are both pros and cons of doing so. Borrowing from your 401K is

[00:02:11] essentially borrowing money from yourself, but there's much more to it than that.

[00:02:15] So before you decide to take out a 401K loan, weigh your options and determine

[00:02:20] if it's really worth it. What Is a 401K Loan? A 401K loan is borrowing money directly from your

[00:02:28] 401K account balance. You then repay the loan with interest directly back to yourself into your

[00:02:34] 401K account. Your exact repayment plan is dependent on the amount you borrow and your

[00:02:40] 401K plan's interest rate. Note, a 401K loan is different from withdrawing money from your

[00:02:46] 401K account. When you withdraw money from your 401K account, it's subject to taxation.

[00:02:53] Also, if you're under the age of 59 and a half, you will pay a 10% penalty for early withdrawal.

[00:03:00] There are a few exceptions related to hardship. How much can you borrow with a 401K loan?

[00:03:06] Though a 401K loan seems straightforward, when it comes to how much you can borrow,

[00:03:11] things get a little more complicated. The allowable amount depends on whether or not

[00:03:16] you have an outstanding 401K loan balance in the prior 12 months. If you haven't had a 401K

[00:03:23] loan balance for 12 months, in this case, the rules for borrowing from a 401K are pretty clear.

[00:03:30] You're allowed to borrow up to 50% of your vested 401K balance or $50,000, whichever is less.

[00:03:38] Examples include, if you have $120,000 in your account, you can borrow up to $50,000.

[00:03:46] And with $70,000 in your account, you can borrow up to $35,000.

[00:03:52] If you've had an outstanding 401K loan balance in the last 12 months,

[00:03:58] in this situation, things get a little more tricky. You use the same 401K loan rules as we just

[00:04:04] discussed, but reduce the amount you're allowed to borrow by the largest 401K loan

[00:04:09] balance you've had over the last 12 months. Examples include, you have $120,000 vested in

[00:04:17] your 401K account and your largest 401K loan balance in the last 12 months was $10,000.

[00:04:24] Then you can borrow up to $40,000, which is $50,000 minus $10,000. And you have $70,000

[00:04:32] in your account and your largest 401K loan balance in the last 12 months was $5,000.

[00:04:38] Then you can borrow up to $30,000. What's the interest rate on a 401K loan?

[00:04:45] The interest rate for a 401K loan is commonly 1-2% more than the prime rate.

[00:04:51] That being said, the actual loan interest rate you're charged is dependent on your

[00:04:56] specific 401K plan. What are the terms for repayment?

[00:05:01] Most 401K loans are due within five years, but it depends on your specific plan.

[00:05:08] Some plans make exceptions and extend the terms to 10 or more years for home purchases.

[00:05:14] Note, the term of the loan is only applicable if you stay with the employer that sponsors

[00:05:19] the 401K plan you borrowed against. Here's one of the most significant risks associated with

[00:05:26] taking out a 401K loan. If your job is terminated for whatever reason with the employer who

[00:05:32] sponsors the 401K plan you borrowed against, the loan is due within 60 days.

[00:05:39] If you do not repay it within 60 days, the loan defaults.

[00:05:44] How can you use the funds? Most plans don't place restrictions on what a 401K loan can be used for.

[00:05:51] That being said, some plans only lend money if you use it for specific reasons,

[00:05:56] such as education, a first-time home purchase, or medical expenses.

[00:06:00] What happens if your 401K loan defaults? Your 401K loan will go into default if you fail to make

[00:06:08] payments or otherwise do not comply with the specific terms of your loan. This also means

[00:06:14] that if you lose or quit your job and you do not repay the loan amount within 60 days,

[00:06:19] your loan will default. When you default on a 401K loan, the money you borrowed is then

[00:06:25] considered a distribution from your 401K account. If it's counted as a distribution,

[00:06:31] you will pay taxes on it. If you're younger than 59.5, you will pay a 10% penalty,

[00:06:37] and you will not be able to use the borrowed funds to roll over into an IRA.

[00:06:42] If you default on a 401K loan, it's not reported to the credit bureaus and will not

[00:06:47] negatively affect your credit score, but that doesn't mean it can't have negative consequences.

[00:06:53] Some lenders will ask specifically about 401K loan defaults, and this could still affect your

[00:06:58] ability to get a loan. How do you get a 401K loan? Unlike most other loan applications,

[00:07:05] borrowing from your 401K is relatively simple and straightforward, and your credit score isn't

[00:07:10] a requirement for this type of loan. Most human resources departments can provide the

[00:07:15] paperwork you need to apply for the loan. Pros and cons of obtaining a 401K loan

[00:07:23] Pros of 401K loans No credit check to qualify

[00:07:28] Easy loan application process with minimal paperwork

[00:07:32] Access the money quickly Not reported to credit bureaus,

[00:07:36] which means it does not boost your credit score as you pay it off,

[00:07:39] but it also doesn't affect your credit score if you default.

[00:07:42] And interest payments are made back to your account.

[00:07:46] Cons of 401K loans The significant risk associated with default

[00:07:53] 10% penalty and taxation Loan due in full within 60 days of termination of employment

[00:08:00] Missed investment returns while money is not in the 401K

[00:08:05] Administration fees Loan payments are not considered 401K contributions

[00:08:11] Some employers will not allow you to make additional 401K contributions while you're

[00:08:15] repaying a loan. Repaying a 401K loan does not increase your credit score.

[00:08:22] The interest portion of the repayment is taxed and lost retirement savings.

[00:08:28] Still considering a 401K loan? Keep in mind, while certain circumstances may

[00:08:34] make you consider it, you shouldn't rely on your 401K for unexpected or unplanned expenses.

[00:08:40] That's what emergency funds are for. Before you take the leap,

[00:08:44] remember that your 401K may be your only retirement savings.

[00:08:49] Most people don't have pensions anymore, so many will rely on the money saved in their

[00:08:53] 401K to get them by in retirement. You just listened to the post titled,

[00:09:01] 401K loans, what are their pros and cons? By Amanda of womenwhomoney.com

[00:09:08] and I'll be right back with my commentary. Looking to part ways with complicated,

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[00:09:17] with USPS Ground Advantage shipping from the United States Postal Service.

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[00:10:59] While I'm sure there are probably situations where a 401k loan is a good idea,

[00:11:05] I personally cannot think of even one. For me, taking on a 401k loan would require some pretty

[00:11:14] dire circumstances, where I needed money immediately for some life-threatening emergency.

[00:11:20] I had no other reserves, no options for increasing my income, I didn't qualify for

[00:11:26] any other type of low-interest debt, and no one on the planet was willing to lend me some money.

[00:11:32] I can't imagine why I would need a loan so bad that I would risk my retirement savings

[00:11:38] and that I'd be willing to interrupt my money earning more money.

[00:11:43] I'm mostly here of people taking a 401k loan to fund a down payment on a house,

[00:11:48] do home improvements, or consolidate debt. That sounds ludicrous to me.

[00:11:54] When I invest my money, I do it for the long term, and I'm so firm in my commitment to not touch the

[00:12:01] money I have invested, I actually think of it as a tax I've paid to my future self.

[00:12:07] That money is gone. I have no claim to it because it's not my money. It's future Diana's money,

[00:12:15] and she says no any time I ask for some. And that should do it for today. Have a happy

[00:12:20] rest of your day, and I'll see you on the Thursday show tomorrow where optimal life awaits.