When to Borrow from a 401k: Exercising Caution

There are two methods to borrowing from a 401k account. The first is to take a loan against the vested amount you have saved. The second is to withdraw from your account. Both options have financial penalties.

Loan against a 401k

Your employer may offer a program to extend you a loan in certain situations. The loan will typically be very high interest. The loans are short-term loans and you will have to repay most of them in 5 years. If you do not, then you will be considered to be in violation of 401k withdraw policies, and you will face additional financial penalties. Your funds will not be earning interest while they are out on loan, making the loan rate even more expensive.

401k Withdraw

A withdraw is even more hazardous than a loan. In this case, you will still have to pay taxes on the amount you take out. In addition to the taxes, you will have to pay a 10% early withdraw penalty for taking the funds out before you are 59 1/2. Because of these financial penalties, a withdraw should only be considered if a loan is absolutely not an option.

Are there any fees associated with 401k loans?

Borrowers have to pay one-time loan origination fees on any 401k loans. An origination fee can range from $50 to $100 regardless of the size of the loan. Therefore, it is wise to take a 401k loan only if the amount is very large and you have no other options. For example, paying a $100 fee on a $1,000 loan is the equivalent of paying a 10 percent origination cost. Paying the same fee on a $20,000 loan results in only a .5 percent fee. You will also owe interest on any 401k loan, but you will be paying this interest back into your personal 401k account.

Can you borrow from your 401k without paying taxes?

You do not have to pay taxes when you borrow from your 401k as long as the money is repaid within the given time frame. The time frame will be anywhere from 10 to 30 years depending on your plan. If you do not repay the money by the time this period has expired, you will be facing penalties equivalent to those on an early withdrawal. This means that you will owe not only income taxes but also a 10 percent penalty. It is wise to take a loan from your 401k only if you have a very limited risk of not repaying the debt.

Is there any other way to borrow from my 401k if my employer doesn't offer the loan option?

Your employer must approve your request to borrow from a 401k. However, there are a few options to pursue outside of a 401k loan if your employer does not approve this:

  1. Qualified Withdrawal - If you are going to use the money for the down payment on a first home or for qualified education expenses, you can take an early withdrawal from your 401k without paying the 10 percent penalty.
  2. Qualified Rollover - Your own your 401l. You can choose to move the money out of this retirement plan into your own IRA. This must be done within a short period of time, but there is a window when you can use the money to pay for emergency expenses as long as it is rolled into your retirement account by the deadline.