If your employer allows you to take loans from your account, then you likely have to be an active employee to do so. The rules around these loans differ, but usually the max loan is $50K or 50% of your account value, whichever is smaller.
Here are some other rules that are typical of 401K Loans:
- You must pay interest back to your account
- You will typically have 5 years to pay it all back
- You must pay it all back within a short period of time (usually 30-60 days) if you leave your job
- If you don’t pay it back in time or after you leave the job, the remaining balance of the loan will be taxed and have penalties
It may feel like you’re hooked into your employer pretty deeply once you take a 401K loan. You may find yourself “stuck” in a job if the chips don’t fall correctly.
Additionally, taking out a loan can hurt your overall savings strategy. You’re using money you’ve already paid taxes on to repay the loan. The problem is that it is taxed again when you take the distribution from the 401K later so you’re willingly taking on double taxation on whatever amount the interest was. No one wants that!
I usually help clients avoid taking 401K loans but there are a few times where it isn’t the worst option:
- Extreme emergencies you were not prepared for with your emergency fund
- Short-term loans – An example of this may be to purchase a new car while waiting for the insurance payout. The idea being that you’d pay off the loan with the insurance money.
- Home purchase – Again, not recommended, but some of the rules around payback periods and the like are loosened when buying a home. Again, this should be used more like a short-term loan with a plan to have it paid back quickly.
Here are some options you may want to consider before looking to your 401K:
- Using emergency funds – This is why we pound the table about having some cash on hand for unexpected expenses
- Using Home Equity Lines – Sometimes you have the opportunity to borrow against your property. This may be a better option as you will have smaller chances of negative consequences.
- Using other investment accounts – Many any other types of investment account is better to tap for needed funds than a 401K such as a standard brokerage account
It’s important to consult a financial professional before taking a 401k loan, just as with any other big financial decision. You often have better options than taking a loan from your 401K but there are dire situations where it might make sense.
The main thing to remember is that there are more pitfalls than benefits when borrowing from a 401K so be careful about this decision.