Pros and Cons of 401K Loans

If you need cash, borrowing from you 401k retirement plan may be an option to consider. However, be sure to evaluate the 401k loan pros and cons before dipping into your retirement funds.

Pros of 401k Loans

Convenience. Obtaining a 401k loan usually is as easy as contacting your company's human resources department and filling out and submitting a short loan application. There is no applying for a loan with a bank and no credit check. Typically, you can borrow a maximum of 50% of the vested balance in your 401k account or $50,000, whichever is less. Usually, you will have to repay the loan within five years, although if you borrow to purchase a first home, you may be allowed to repay the loan over a longer period.

Low Interest Rate. The interest rate on a 401k loan usually is relatively low, perhaps one or two percentage points above the prime rate.

Repay Yourself. Interest and principal payments on your 401k loan are made to yourself.

Tax-Free Interest Income. You don't have to pay income taxes on the interest you receive (from yourself) on your 401k loan, although taxes will be due when it is withdrawn from you 401k account in the future.

No Penalty or Taxes. There are no penalties or income taxes owed on money borrowed from you 401k, whereas permanent withdrawals are taxed no matter what your age and are hit with a 10% penalty if you are less than 59 ½ years old.

Easy Repayment. Interest and principle payments on your loan usually are deducted directly from your paycheck, making the 401k loan repayment process easy and efficient.

No Prepayment Penalty. You can repay you 401k loan in full at any time without a penalty.

Cons of 401k Loans

Lost Tax-Free Earnings. Money borrowed from a 401k will not be generating tax-free income in your retirement account until it is repaid to your plan. As a result, you could be forfeiting a substantial amount of interest, dividends and/or capital gains during the period that a 401k loan is outstanding. This can have a permanent effect on your account's growth, since, even after the loan is repaid, your account balance is likely to be lower than it would have been otherwise. Also, some borrowers reduce or eliminate their 401k contributions while they are repaying a loan, resulting in a double whammy on their account's balance and its long-term growth.

Repay with After-Tax Dollars. Your 401k loan is made with pre-tax dollars that were deposited in your 401k account or that were earned, tax-free, on contributions to the account, but the loan will be paid with after-tax dollars. Therefore if you take out a $50,000 loan from your 401k and you have a marginal federal income tax rate of 28%, you will have to earn $69,444 pretax to repay just the principal on the loan. In addition, you will pay taxes on the $50,000 when it is withdrawn from your account in the future.

Repayment Risk. If you don't repay your 401k loan, you will have to pay state and federal taxes on the unpaid loan balance and possibly a 10% penalty (if you are less than 59 ½ years old).

Loan Due If Leave Company. If you leave your job before your 401k loan is fully repaid, the loan balance will be due immediately (usually within 60 days). As a result, it is not a good idea to take out a 401k loan if you expect to leave the company before the loan is repaid or if you think you may lose your job.

No Interest Deduction. Interest on a 401k loan is not tax deductible, even if the loan is used to purchase a home.

Restrictions and Fees. There may be restrictions and/or fees on your 401k loan, depending on your company's rules. For example, you may have to pay an administrative fee when you take out the loan and you may have to obtain your spouse's approval before getting a loan.

Sources:

Ginger Applegarth, moneycentral.msn.com, The Basics - Warning: 401(k) loans are hazardous to your wealth - MSN Money

www.guideto401kloans.com, guide to 401k Plan Loans and Withdrawals