What are the Pros and Cons of 401k Loans?

Sara Schmidt

Though people may wish to obtain 401k loans while facing financial adversity, it can carry a heavy price, such as a rigorous automatic repayment schedule out of one's paycheck. This can reduce the amount of a person's take home pay, as well as potentially disallow him from contributing further into the account until the loan is repaid. Some benefits can be reaped from taking out 401k loans as well, such as having a smaller interest rate than a bank would typically charge for a loan.

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

Many financial advisers would suggest obtaining funds through another means rather than receiving a 401k loan. Though the repayment schedule for the loan may provide the recipient with up to five years to fully repay the funds to the account, it still includes interest. A reduced amount of take home pay will also occur, potentially pushing workers with financial hardship further into a pinch.

Depending upon the employer and the account, taking out a 401k loan may make an employee ineligible to contribute to his or her own retirement plan until the loan is repaid. This may greatly reduce the employee's retirement money, especially if the loan spans beyond the maximum five years allowed for repayment. Workers should check their plan policies prior to taking out a retirement loan if they wish to avoid this penalty.

Failure to repay the loan can result in heavy penalties. If an employee leaves his or her place of employment due to a new job, a layoff, or other reasons, his or her 401k loan will no longer be considered a loan. Instead, the money is now considered an early 401k withdrawal, which can be very costly. It includes a 10% penalty on the full loan amount. The borrower must also list the loan on his or her income taxes for the year, possibly resulting in owed federal or state taxes.

Still, the benefits of 401k loans may sometimes outweigh their drawbacks, depending upon the individual borrower's circumstances. With lower interest rates than a bank or payday loan center might charge, 401k loans can save borrowers money if they are planning to borrow money regardless of the source. The repayment period may also be longer than other financial institutions offer, providing the borrower with sufficient time to repay the loan without spending too much money at once to do so.

401k loans also require no credit checks. This can be helpful for people with no established credit or poor credit, who require financial assistance. Retirement loans are also distributed quickly, with many borrowers receiving their money within one week after requesting it. The process for borrowing is also considered simple, with less paperwork than a bank transaction. The entire process may be able to be completed via telephone as well; nevertheless, borrowers should not allow the ease of obtaining the loan to become an incentive for choosing this path without careful consideration.

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