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What are the pros and cons of taking a 401K loan?

AdobeStock_16747416-300x221Many employers provide 401k plans for their employees.  A 401k plan is a retirement savings plan where employees can save a portion of their pre-tax earnings. Taxes aren’t paid on the money until it is withdrawn from the account.

Some, but not all, 401k plans permit employees to take out a loan against the 401k. Just because you can, doesn’t mean you should.  Here are the main things to consider before you take a loan against your 401k account.

Loans against 401k accounts come with all of the same formality as any other type of loan. There will be a loan agreement that sets forth the terms of the loan, the interest rate, and any fees associated with the transaction. Just because you are borrowing your own money, don’t assume you will get a great deal on the interest rate. The interest rate you will be charged will be comparable to the rate a conventional lender would charge for a similar-sized personal loan.  If you have poor credit, however, you may get a better interest rate than you would at a bank.

Be aware that the IRS limits the amount that can be borrowed from 401k plans. On the plus side, you don’t usually have to explain why you need the loan. And since you are borrowing the funds, rather than making a withdrawal, you won’t have to pay an early withdrawal penalty.

Generally, 401k loans must be repaid within five years, unless the loan will be used toward the purchase of the borrower’s primary residence.  Unlike mortgage interest, which is tax deductible, the interest on a 401k loan is not deductible, even if it is used to buy your home.

Payments on the loan are typically made through payroll deductions with after-tax dollars. You will be taxed again when the money is eventually withdrawn from your 401k plan.

If you change employment while you still have an outstanding 401k loan balance, you may have to repay the entire loan balance within ninety (90) days of leaving your job.

The money in your 401k plan won’t grow if it isn’t invested. Think carefully before you use your retirement savings.  Borrowing from your nest-egg could be detrimental to your long-term financial security and shouldn’t be done lightly.