Borrowing from 401(k) and Its Pros and Cons

While taking a loan from your 401(k) plan you need to be an employee, but not all companies allow loans. So, before you rely on this, check if your plan permits you to do so. You can find this on the plan documents or you can talk to your HR or plan representative. If you are eligible, you need to make an informed decision before you apply for a loan. Let’s take a look at some pros and cons of borrowing from 401(k).

Pros

• No loan application is required
• You don’t need to have a credit score
• The repayment is automatically deducted from your paycheck from one to five years

Cons

• There is double taxation on the interest component. The interest is repaid to your 401(k) plan after-tax money. If you do not take a loan, you earn tax-deferred interest. Also, you can only be taxed when you withdraw. By borrowing, you have to earn the money and pay taxes on it to put the money back into the plan. Once it is withdrawn, it will be taxed again. This defeats the purpose of a tax-deferred account.
• If you have left the job, you need to repay the loan or any outstanding balance, which can be treated as taxable payment unless repaid entirely within a certain time limit.
• The money withdrawn is protected from any bankruptcy and creditors. If you wish to borrow and pay off debts, you may just end up using all the money.

Why people take loans from 401(k)

People borrow money for many reasons. They are:

• To start-up a business
• Help an adult child
• To buy a car
• To pay off a debt

In case you want to borrow money for the above-mentioned reason, think twice. This may hurt your retirement savings but borrowing may lose the compound interest. Think about yourself at an older age and try not to break the nest egg.

Instead, explore the other options to borrow money. Connect with other business persons to borrow and repay money to help fund a business. Furthermore, understand 401(k) repayment rules before you do anything else.

Who should not borrow

• To get out of debt, you need to get your finances in order. Leaving the money in 401(k) keeps it protected from creditors and bankruptcy. If you change jobs or lose the job and are unable to repay the loan, it may leave you indebted in taxes and penalties to the IRS. Before borrowing, consider all other options to reduce or eliminate debt. If you are borrowing, make sure you are committed to repaying the loan.

Alternatives to borrowing
If you have to pay for medical expenses and if you choose to withdraw, you agree to pay the tax on the withdrawal. Talk to a debt attorney or keep a debt repayment plan and to keep the 401(k) intact.