When you need some fast cash, it can be tempting to look to your 401(k). You're allowed to borrow up to the lesser of $50,000 or 50% of your vested account balance, and while you will have to pay interest, that money will go toward your retirement instead of into a creditor's pocket. It seems like a win-win, but there are some drawbacks to this approach that you should know before you use it. Here's a closer look at the most important things to keep in mind before borrowing from your 401(k).
1. You could be taxed on the money
You typically have five years to pay back the amount that you borrowed, plus interest, though the repayment period may be longer if you use the money for a down payment on a home. If you can't pay back the full amount by the end of this period, the outstanding balance will be considered a distribution.
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The distribution will be subject to income tax, which for most people will be either 12% or 22% in 2018. If you're on the bubble between two tax brackets, it's possible that this distribution could push you over into the higher bracket, requiring you to pay even more in income tax than you had originally anticipated. And if that isn't bad enough, individuals under age 59 1/2 must also pay a 10% early withdrawal penalty.
So if you borrowed $15,000 and only managed to pay back $5,000 during the repayment period, you'd be taxed on the additional $10,000. Assuming a 22% income tax, you'd owe $2,200 on this balance, plus another $1,000 if you're under 59 1/2. If you aren't confident that you can repay the money within the repayment period, you're better off leaving it in your 401(k) to begin with.
2. You have to pay the loan back when you leave your job
If you quit your job or are laid off during the repayment period, the balance of your loan will come due. You'll usually have 90 days to pay it back, but if you can't, it becomes a taxable distribution, subject to the same rules listed above.
Consider your position at your job before borrowing from your 401(k). If you plan to leave within the next couple of years or if you think that your job isn't very stable, a 401(k) loan isn't a smart idea.
3. You'll hurt your retirement savings
When you borrow from your 401(k), that money no longer earns compound interest, which slows the growth of your retirement savings. You will have to pay back what you owe with interest, but that interest rate often does not compare to what you would have earned by leaving the money in your 401(k).
Imagine you borrowed $10,000 from your 401(k) with a five-year repayment period. Your interest rate is prime plus 1 percentage point, which means you'll pay 1 percentage point over the prime rate, which is currently 5%. You would pay $193 per month and end up paying about $1,600 in interest, so that $10,000 would end up being worth $11,600 by the time you paid back the loan. But if you had left that $10,000 in your retirement account, it would have grown into $12,293 by the end of the five years -- a difference of $693. It might not seem like that big of a deal, but over 30 years, that $693 could grow into an extra $7,611. That's enough to cover living expenses in retirement for a couple of months.
Alternatives to borrowing from your 401(k)
If you've decided that borrowing from your 401(k) isn't your best move, there are other ways to get the money you need. Family and friends may be willing to offer an interest-free loan, but it's important to discuss the terms and only borrow what you know you can pay back.
You may be able to charge the money to a credit card if you need to borrow money for only a short time. But high interest rates make this a poor choice for long-term borrowing. If you are going to charge the money to a credit card, look for one that has a 0% introductory APR period and ensure that you can pay back the balance in full before this period is up. Otherwise, you risk falling into credit card debt.
A personal loan is another option, though interest rates can reach as high as 36% for borrowers with a poor credit score (about 640 or less). Plus, the interest you pay will go to the lender instead of to you. But you'll have a fixed monthly payment and you won't risk damaging your retirement savings.
It can be tempting to borrow money from your 401(k), but in most cases, the cons outweigh the pros. Make sure you think through all of your options carefully before deciding to take out a 401(k) loan, and stay on top of the payments so you aren't taxed for an early distribution.
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