Some people borrow money from their 401(k) plans whenever they find themselves in a financial bind. Most of these people think that they can do anything with it. After all, it is their money. However, while you are allowed to borrow as much as 50% of your 401(k) balance, you should only consider it after you have exhausted all your options. Here's why.
You can only borrow a small amount. You cannot borrow much from your 401(k) plan since you can only borrow up to 50% of your account balance or up to $50,000 for those who have a vested account balance of $100,000 or more. In addition, any outstanding loan from your 401(k) plan within the last 12 months will also be deducted from your new loan.
The loan needs to be repaid within 5 years. You need to make quarterly payments and repay your loan within 5 years. There are some exceptions to this rule since you can take a break from paying your loan for up to a year but you still have to pay the remainder of the loan within the original 5-year term.
It will adversely affect your take home pay. A 401(k) loan may put more pressure on your personal budget since you have to repay it through payroll deductions. This can be bad if you are already having difficulties making both ends meet.
It can be expensive. Borrowing from your 401(k) can be expensive, especially if you choose to leave your current job or are laid off before you have paid your loan, since you are required to pay back every last cent of what you have borrowed within 60 days. If not, you will be hit with early withdrawal penalties (up to 10% of the total loan amount). Your original loan will also be added to your taxable income and will be taxed accordingly. In addition, by borrowing from your 401(k) plan, you will incur a number of loan-related expenses including all those expensive origination, administration and maintenance fees.
You may end up with higher taxes. If you are maxing out your 401(k) contributions to get a lower income tax bracket, you may end up in a higher tax bracket after taking out a loan from your 401(k) plan. Remember, your payments will be taken out after taxes.
It may negatively affect your retirement nest egg. Some plans do not allow you to make your regular contributions until you have paid your loan in full. Since you have not maximized your saving potential, you will ultimately have less during your retirement years.
Keep these things in mind before taking out a 401(k) loan. It may not be the best option, after all.