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How to Take a 401(k) Loan – And Why You Shouldn’t


As the economy hiccups, more workers are turning to 401(k) loans for emergency cash. According to a recent study by the Transamerica Center for Retirement Studies, 18% of U.S. workers took a 401(k) loan last year. That’s an increase from 11% in 2006. Taking a loan from your 401(k) account is not difficult, but it’s not a good idea.

The temptations to take a 401(k) loan are plenty: to make a down payment on a home, to pay down high interest credit card debt, or as an alternative to traditional loans amidst a tighter lending market.

So, What Is a 401(k) Loan?

A 401(k) loan is a lump-sum disbursement from funds that you have saved in your retirement account. You must repay the loan over a fixed-amount of time – with interest – back into your 401(k) account. You can borrow between sixty and eighty percent of your 401(k) balance, and occasionally up to the full account value. The loan is set-up through your 401(k) plan administrator.

In some ways, a 401(k) loan seems like a good idea. Essentially, you borrow money from yourself, so interest charges go right back into your retirement account instead of to the bank. And, since it’s secured by your own money, there is no credit check to take a loan, and you can’t default and find creditors knocking down your door.

Why 401(k) Loans Are Bad

Despite these apparent benefits, 401(k) loans are a bad idea for two reasons. First, when you borrow money from your 401(k), those funds stop earning compound interest until they are repaid. Even if your 401(k) balance is small, a couple hundred dollars in interest over a few years could turn into many thousands over 30 years.

Even more important, contributions (including loan repayments) to your 401(k) are dependent on you being eligible to receive that benefit from your current employer. If, for any reason, you leave your employer, the entire balance of your 401(k) loan becomes due.

Can’t pay up? The remaining loan balance will be treated as a pre-mature cash withdrawal form your 401(k), subject to at least a 20% federal income tax, state tax, and a 10% early withdrawal penalty. So if you borrowed $10,000, had repaid $2,000, and lose your job – you are freed up from repaying the $8,000 to your retirement account, but you will be hit with a $2,400 federal tax bill.

That’s one expensive loan.

How to Take a 401(k) Loan

If you’re really in a pinch, or absolutely can’t get an alternative loan source, you can take a 401(k) loan by talking to your human resources or benefits manager at work, or by logging into your 401(k) plan’s website. Some plan providers – including John Hancock and Fidelity – allow you to request loans online.

Related Articles

Have you taken – or considered taking — a 401(k) loan? Why did you do it, and how did it work out?

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About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. Is this true? When you pay back the loan you are paying it back with after tax dollars instead of pre tax dollars. So when it comes time to withdrawl for retirement, you get taxed again?

  2. You aren’t being taxed for the portion of the loan you pay back – but for the portion you DIDN’T pay back. In the example above, the taxes recovered were for the $8000 that weren’t paid when that money was deposited in the 401K account.

  3. It is not true that the money is taxed twice (you could make a case for the interest being taxed twice depending on your plan). But say i took out a loan 10,000 from my 401k then the next day I paid it back with the same money. Did I get taxed twice in this scenario when i take out that money in retirement? Clearly no taxes were only applied once to the money in that scenario. Think of it this way if you borrowed from the bank and paid the bank back with after tax dollars were you taxed twice? just because youre paying back a loan you took pretax from yourself with post tax dollars doesnt mean that money is getting taxed twice because the loan amount never gets taxed.