What are the Best Tips for Borrowing from a 401k?

A.E. Freeman

Although 401ks are designed to be held until a person's retirement, there may come a time when borrowing from a 401k is necessary. If a person is planning on buying a new house and needs money for the down payment, borrowing from a 401k may seem like a better option than borrowing money from a bank. Borrowing from a 401k is not a good option for everyone, though. A person should only take out the money if she knows she can repay it within the allotted time frame, usually five years, and if she plans on staying at her current employer for the duration of the loan.

Information about 401k plans.
Information about 401k plans.

Many 401k plans only allow people to take out loans under certain circumstances. Before attempting to borrow the money, a person should check to make sure the intended use of the loan, such as paying for a car or paying down a debt, are valid reasons for borrowing from a 401k. If the reason is not valid, then the person may have to make a hardship withdrawal from his account, which comes with penalties such as a 10-percent tax and income tax on the withdrawn money.

Many 401k plans only allow people to take out loans under certain circumstances.
Many 401k plans only allow people to take out loans under certain circumstances.

Borrowing from a 401k should really only be done if a person has no other options for paying down debt or paying certain expenses. It is not a good idea to borrow money from a 401k to pay for frivolous items, such as an expensive vacation or a new entertainment system. The loan should really only be taken out in times of hardship.

The process of borrowing money from a 401k is usually very simple. In some cases, a person simply has to call her bank to request the loan or fill out a short form. Usually, a person can borrow as much as 50 percent of the funds in her account provided it is not more than $50,000.

Repayment is also very simple, as the funds are deducted from a person's paycheck. Unlike the original contributions, the repayment funds are not pre-tax. If a person leaves his job, the entire loan becomes due immediately or else transforms into a hardship withdrawal.

Although a person usually has five years to repay the loan, if she uses the money to buy a house, she has a slightly longer repayment period. Interest on a 401k loan is generally less than interest on a bank loan and far less than interest on a credit card. One benefit is that the borrower pays the interest to himself. One downside is that the interest paid on the repayments is usually less than what the money would have earned if it remained in the 401k.

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