The following is a guest post from Ben at Trees Full of Money
Most financial planners will advise you not to borrow money from your 401k with the concern that you may “miss out” on market gains. However, if you need cash and your financial situation leaves you no other alternatives, borrowing money from your 401k might help you get your financial life back on track.
Each 401k plan is different so be sure to read your plan’s terms completely before taking a loan.
How Does it Work?
In general when you borrow money from your 401k the funds are directly taken from your account balance. For example, if you have $50,000 in your 401k account and you borrow $10,000, your account balance becomes $40,000. You then begin paying the loan back through additional paycheck deductions depending on the term of the loan. The obvious drawback here is that $10,000 is no longer working for you in the stock market (or bond fund) and potentially loosing out on any appreciation.
On the other hand (in most plans) the interest that you pay on the funds that you borrow goes directly back into your account. That’s right, you are paying yourself interest! When I borrowed money from my plan 6 years ago the interest rate was 8%. Ironically, during the payback period, the stock market lost value and I came out ahead.
Typically, you pay the loan back with after tax money subtracted directly from your paycheck in addition to any other contributions you normally make to your 401k. In other words, if you are already contributing $100 a paycheck (before tax) to your 401k, you will still have that deducted from your paycheck in addition to the monthly payment amount for the loan.
What Are the Drawbacks?
As mentioned earlier, borrowing money from your 401k is discouraged because you are missing out on potential market gains that have historically been above 11% per year. You may get lucky like I did but chances are that over time you will loose money.
Also, consider that if you quit, are laid-off, or fired from your job, the balance of your 401k loan may come due immediately, otherwise it will be considered an early distribution by the IRS and is subject to a 10% early withdrawal penalty in addition to any regular income tax that may be due on the proceeds.
There are additional fees associated with processing a 401k loan as well. Fidelity charged me a $35 upfront fee as well as $3.75 per quarter to cover “administrative” expenses.
When to Borrow From Your 401k
Only borrow money from your 401k (or other retirement accounts) as a last resort. I made the decision to borrow money from my account after realizing the foolish mistake that I had made when I leased my Toyota 4Runner. I borrowed the difference that I was upside down on my vehicle sot that I could get a better term on my auto loan. Borrowing money from your 401k for medical expenses or to avoid foreclosure are other obvious times that it may make sense to you.
When Not to Borrow From Your 401k
As you may of guessed, borrowing money from your 401k for a family vacation, new plasma TV, or paying for VIP seats at the Super Bowl is not a wise financial decision!
Remember to read your plans literature carefully as each plan has different rules. Hopefully you’ll never have a legitimate reason to borrow from your 401k but if you are considering it good luck!