I’ve always said that borrowing from your 401(k) is a bad idea. However, the other day I was talking with my friend Miller when I erroneously told him that one of the reasons I thought it was a bad idea was because you paid back the loan with post-tax money even though you borrowed pre-tax money. You don’t pay back with post-tax money, you pay your loan back through payroll deductions so it’s with pre-tax money. If I was wrong on that point, I had to do more research to see if my opinion of borrowing from 401K’s was even right in the first place.
It turns out, thanks to reader Tom who confirmed this, that you pay back the loan with post-tax dollars, so my original understanding was correct. I still think 401K loans are a bad idea and the fact that you pay back with post-tax funds make it even worse.
A few things to note, while the law allows your employer to offer the 401K loan, it doesn’t require your employer too. While it’s estimated that most employers do offer it, not every single one of them does so check first before you start making plans. If your employer does, then you’ll generally be allowed to borrow up to 50% of your vested account balance up to $50,000 as long as you haven’t taken a loan in the last twelve months. If you have taken one in the last twelve months, then your max is deducted by that loan amount – basically each 12 months you can borrow up to 50% or $50k, whichever is smaller. There are a few other rules specific to your employer like the minimum loan amount (this is just to reduce the headache of paperwork) and any associated fees.
Here are the advantages of borrowing from your 401(k):
- It’s generally really easy, no applications, no credit checks, none of the annoyances with typical loan application processes.
- Decent interest rate, generally a point or two above the Prime rate, and that interest is paid to your own account anyway.
What are the disadvantages?
- That interest rate is usually less than what the account could earn on its own with the money, plus you’re paying it anyway so it’s not coming from the market.
- The loan payment taken from your paycheck might tempt you to reduce your contribution resulting in less in savings.
- If you leave your employer, for any reason, you have to pay back the loan immediately (or within 60 days). If you can’t, it’s considered a withdrawal and you’ll owe taxes and a penalty on it.
- The terms of the loan are set in stone and there might be some fees involved. You generally pay back the loan over 5 years, it’s more if you use it to purchase a primary residence (10-15 years).
So, should you borrow from a 401k? That depends! 🙂