What You Need to Know About 401K Loans

Borrowing money from yourself can seem like a clever idea when there are cash flow needs your income cannot meet. With the average balance on 401Ks below $100,000, such a move could have lasting effects on retirement income.

There are many advantages to 401K loans which include the following: Most employers allow loans against your 401K account, providing access to retirement funds before 59 ½, without paying penalties or taxes on the money. You do not need to qualify for the loan, giving those with poor or strained credit access to cash. The loans carry a low-interest rate, typically feature automatic payroll deductions for repayment, and you get all interest paid on the account minus administration fees.

The IRS allows you to borrow the smaller of 50% of vested loan balances or $50,000. Company policy dictates whether this figure includes company contributions to the account or not.

There are also significant drawbacks to 401K loans, putting them in the emergency only category. When reducing retirement account balances, you lose the advantage of compound interest. Funds no longer grow in the account while you have an outstanding balance. Most borrowers stop or reduce contributions while repaying the loan, further damaging retirement balances. Another significant disadvantage is the loss of the tax benefits associated with retirement accounts. Money contributed to these plans use pre-tax dollars. You repay the loan with after-tax dollars, costing you more upfront. You again pay taxes on the money when withdrawing in retirement. Reducing 401K balances can permanently reduce total investment dollars available in retirement.

While 401K loans can seem like an easy fix to financial challenges and shortfalls, it can be a very costly decision that expands well beyond the payback period. Use caution before tapping into any funds earmarked for retirement needs.