When you need money, your 401(k) might seem like the best place to turn for a financial boost. But you’ll want to keep in mind that taking money from your account means that you lose out on potential investment earnings for your retirement.
401(k) loans
You may be able to take a loan from your 401(k), to be repaid within 5 years — or 25 years if you use the loan to buy a primary residence. Federal law caps the amount you can borrow from your 401(k) at $50,000, or half the amount you have vested in your plan, whichever is less. The exception is that if you have less than $20,000 vested in your account, you may still borrow up to $10,000.
Most 401(k) loans are repaid with automatic deductions from your paycheck. The interest rate is usually one or two percentage points higher than the current prime rate, and the principal plus interest go back into your 401(k) account. The interest is not tax deductible in most cases, even if you borrow to pay for a primary home. You will also have to pay a loan fee, which is a percentage of either your loan amount or your account balance.
The pros and cons
When it comes to borrowing from your 401(k), there’s good news, and there’s bad news. The good news is that you are essentially paying yourself back, with interest, and you won’t owe income tax on the amount of your loan, as long as you pay it back in time.
The bad news is that you pay income tax twice on the money you use to repay your loan — once because the money deducted from your paycheck to repay the loan is after-tax income, and a second time when you withdraw the money from your account.
Although it may be tempting to stop contributing to your 401(k) while you’re repaying your loan — since money is already being deducted from your paycheck — that decision could throw off your retirement savings schedule. That’s because you’d miss out on both the tax deductibility and the earnings potential of any new contributions.
