When you need cash for a downpayment on a home or when you hit a financial emergency, your retirement nest egg can look pretty appealing. You might have thousands stashed away in a 401(k), so when you need money quickly, taking a loan from your own account can be tempting.
But before you borrow from your own 401(k), you need to know how 401(k) loans work and how it can impact you later on.
What Is a 401(k) Loan?
A 401(k) loan allows you borrow $50,000, or half the amount that is vested, whichever is less, from your retirement savings. You can use the money for whatever you want, such as buying a car or a blowout vacation.
When you take out the loan, it works just like taking out a loan from a bank. You will sign a loan agreement that outlines the amount of the loan, the length of repayment, the interest rate and any additional fees.
Some 401(k) accounts have a minimum amount you have to borrow. For example, if your lender has a $10,000 minimum, and you only need $5,000, you’ll need to take out the full $10,000 to get any money at all.
401(k) loans typically have a repayment term of five years. The only exception is if you’re using the money to buy a home. In that case, you may be able to get a term as long as 25 years.
Drawbacks to a 401(k) loan
While a 401(k) loan can sound like an attractive option, borrowing from your 401(k) can have long-lasting consequences. Here are five reasons why a 401(k) loan is a poor financial decision:
1. Interest: Even though you’re essentially borrowing from yourself, you’ll have to pay back market interest rates on your loan. That can tack on thousands to your principal.
2. Missed opportunities: If you take out a 401(k) loan, the money you withdrawal is used elsewhere and isn’t able to accrue interest and grow in a 401(k). That means you could have substantially less in retirement when you need the cash.
3. Interest isn’t deductible: For most homeowners, you can deduct the interest you pay on a home improvement loan. If you instead borrow money from your 401(k), the interest is not tax deductible. If you’re updating your home, that can mean losing out on significant deductions that could reduce your tax bill.
4. Repayment if you lose your job: If you take out a 401(k) loan and then lose your job, you’ll have just 60 days to repay the entirety of the loan; you’ll have to pay back thousands at once. If you don’t, the loan is considered an early withdrawal. With an early withdrawal, you’re charged a 10 percent penalty, and then you’ll have to include it as taxable income. The money could push you into a higher tax bracket and a much larger bill.
5. Your contributions are put on hold: Some 401(k) plans have a rule that says you cannot contribute to your 401(k) until the loan is paid off. Because of that stipulations, you don’t only miss out on your own contributions, but you also lose the company match if your employer offers one.
3 Better Alternatives to 401(k) Loans
Now that you know all of the drawbacks to 401(k) loans, you might be rethinking borrowing from your retirement. But if you’re in a desperate situation or need money quickly, there are other ways to get the cash you need without raiding your nest egg:
1. Personal loan: If you need money for home improvements or an emergency, a personal loan can give you the necessary funds without collateral. While personal loan lenders generally charge higher interest rates, your 401(k) will remain untouched and continue to grow. You can apply online for up to $35,000 and get approved in just a few minutes.
2. Zero-interest credit card: Another option is to take advantage of credit cards with a 0% interest promotional period. Many give you up to 15 months to use the card before they start charging interest. That perk allows you to make purchases and pay them without the balance ballooning with interest charges.
3. Launch a side hustle: Many take out 401(k) loans to fund a big purchase, like a new car or a downpayment on a home. A great way to accelerate your savings is to start a side gig on top of your full-time job, such as driving with Uber, delivering groceries, or walking dogs. You can add hundreds to your bank account each month, helping you get the money you need more quickly.
Borrowing from your 401(k) can seem like a smart move, but it’ll cost you in the long run. Instead, explore other options like personal loans or credit card offers to fund your projects while allowing your retirement fund to grow.
For more information about using credit, check out this article on how to choose the right credit card for your needs.
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