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How to Borrow from Your 401(k) Loan

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401k loanSometimes, when you really need the money, raiding that retirement account starts to look really good. Especially if you have no other viable options. A 401k loan can seem like an attractive alternative to a payday loan or some other high interest loan because the interest rate is usually lower, and because you are paying that interest to yourself.

However, even if you are in what you consider a true emergency situation, it’s important that you take a step back and consider your options, and understand what a 401k loan is really all about.

How a 401k Loan Works

When you borrow from your 401k, you withdraw a certain amount of money with the understanding that you will repay the loan, plus interest, within a certain period of time (usually five years). The loan status ensures that you aren’t charged the 10% withdrawal penalty for being  under 59 1/2 years of age, and it also prevents the IRS from trying to take its cut and claiming you owe taxes for income.

When you borrow from your 401k, you provide your employer with a statement regarding what the money will be used for. You may have to pay a loan origination fee, which might deducted from your 401k. During the time funds are outstanding, an employer can choose not to match your contributions — and you may be barred from contributing altogether. Also, realize that if you are laid off, or if you change jobs, you will need to repay the 401k loan within 60 to 90 days. If you don’t, the loan is converted to an early withdrawal and penalties and taxes apply.

401k Hardship Withdrawal

If you are experiencing economic hardship, it is possible to take a hardship withdrawal. A hardship withdrawal works pretty much the same way a regular withdrawal works: You pay your 10% penalty for early withdrawal, and you owe income taxes on the amount you withdraw. (Those who are laid off and at least 55 won’t have to pay a 10% penalty for any withdrawal.)

The difference with a hardship withdrawal is that you can withdraw the money when some plans wouldn’t allow early withdrawals, or when other requirements might be attached to them. Some of the reasons that you can take a 401k hardship withdrawal include:

  • Avoid foreclosure
  • Repair damage to your home
  • Buy a primary residence
  • Medical expenses
  • Funeral costs
  • Tuition

Realize, though, that you can’t make new contributions to your 401k until six months have passed. In many cases, you are better off taking a 401k loan than a hardship withdrawal, especially if you have a plan to repay the loan in a relatively short amount of time.

Think Twice about a 401k Loan

You should always think twice before withdrawing money from your 401k — even if you plan to pay it back. First of all, you could end up in a worse financial situation if you suddenly have to repay the loan because of a job loss.

Another consideration is that you miss an opportunity to earn money. Even though you are paying yourself interest, the fact is that capital in your retirement account is diminished. You can’t reclaim the time your retirement account spent earning less because of the fact that you pulled some of your principal.

(Photo: trenttsd)

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11 Responses to “How to Borrow from Your 401(k) Loan”

  1. Jason says:

    I think you missed another big problem with 401k loans. They are paid back with After tax dollars, not before tax dollars like your standard contribution. So whatever you borrow from your 401k you have to pay back without the tax break.

    • govenar says:

      But if you didn’t have to pay tax when withdrawing the money, then you didn’t lose the tax break from when you initially contributed to the 401k.

      Though, it wasn’t clear to me whether the loan repayment counts towards the annual 401k contribution limit (e.g., $17,000 this year). But based on some web searching, it sounds like the repayment doesn’t count towards the limit.

    • yourPFpro says:

      Jason, this is a huge myth! Google: 401k loan double taxation myth, if you want more info but basically here is the explanation:

      It does not matter who you borrow from, whether it be a bank, family or a 401k plan. You have to pay all of these loans back with after-tax dollars right? A 401k loan is not tax deductible. So it really doesn’t matter what type of money you put into the 401k..

      Make sense?

  2. Anonymous says:

    You also pay interest to yourself. So sometimes you could earn more from the interest you are paying yourself instead of what the stock market is giving you. But being after tax dollars it might end up sixes.

  3. Savvy Scot says:

    @ Jason – you are totally correct. This could be a very expensive loan!

  4. Professor Longhair says:

    The after tax money payback is a red herring. Almost any loan you take out is paid back with after tax money. One other point is that you lock in any gains/loss when you make the withdrawal for the loan. If you think your 401k account will decline it is a smart move.

  5. Dave says:

    Bravo Prof Longhair. Yes, all your loans are paid back with after tax dollars. Even, gasp, a mortgage.

    That they potentially increase your 401(k) value is no different than any other investment return you might get in your 401(k).

  6. skylog says:

    i suppose it is nice to have the option if a situation arises, but this is something that should generally be avoided for most people.

  7. Anonymous says:

    I have a question for anyone, I took out a loan from my 401k through my work three years ago. Now I have enough money to pay it all back. Is there any way I can just pay all of it?

    • Linda says:

      Yes, you can pay back 401K loans early. We’ve done that before and it’s very easy to do online, at least using J.P. Morgan’s website.


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