401(k) loans! Should you take one?

Contributions to 401(k) plans are intended to be used for retirement and as a result, withdrawals are generally taxable and potentially subject to early withdrawal penalties. The money is supposed to be earmarked for retirement and that is why it has tax preferences. Nevertheless, one can borrow up to 50% of the (vested) account balance, with a maximum cap of $50,000 (for accounts with a value greater than $100,000). The loan however must be repaid in a timely manner, which is a period of 5 years or less.

The advantage of a 401(k) loan is that it has a much lower interest rate compared to other lending opportunities. It is a great idea compared to credit card debt and a bank loan. It is a good way to get some cash for an emergency. (Please read my post on Emergency fund). Also, it doesn’t have stringent requirements on qualifying for the loan, beyond completing the brief paperwork and perhaps paying a modest processing fee.

A unique feature of a 401(k) loan is that unlike other types of borrowing from a lender, the employee literally borrows their own money out of their own account, therefore, the loan repayments of principal and interest really do get paid right back to themselves (into their own 401(k) plan). In other words, as long as you can afford the loan repayments, it is effectively a form of “interest-free” loan.

The drawbacks of a 401 (k) loan are that the loan can get treated as a distribution if you change jobs. A 401(k) plan may require that any loan be repaid “immediately” if the employee is terminated or otherwise separates from service (where “immediately” is interpreted by most 401(k) plans to mean the loan must be repaid within 60 days of termination). Also, although you pay interest and get it back, the money withdrawn will not be invested in whatever the 401(k) plan is supposed to be invested in so there is an opportunity cost and therefore you lose some growth along the way.

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