It's Not A Loan
It's Not A Loan
If you were wondering whether or not taking a loan against your 401(k) to pay off credit card debt makes sense, the answer is quite simple. Maybe…
Although it has been tagged with the term, accessing a portion of your 401(k) assets, and making payments to replenish that amount, is not truly a "loan". There are typically no credit checks, nor income requirements to qualify. If you have funds in your 401(k) account, odds are you have already been approved. That's why so many borrow against their retirement funds...its convenience and ease.
Limits and Convenience
The Internal Revenue Service rules allow up to $50,000 or 50% of your vested balance, whichever is smaller, to be borrowed against. A huge benefit of being able to borrow against your retirement funds is the speed and convenience associated with the transaction. Usually the process can be completed within a matter of days. More often than not, consumer loans take a little longer to process.
Pay Yourself Back
Another benefit to borrowing from yourself is the interest rate charged on the funds. Usually the rate is 1% over the prime rate, so if the prime rate is 6%, you’d be paying 7% on the funds borrowed. This lower rate could have a huge influence on your decision if you are looking at paying off credit card debt charging a much higher rate. Here’s the kicker…the interest paid on the amount borrowed from your 401(k) is not paid to a bank, but right back to your retirement account, ultimately saving you even more.
Fees
However, this type of transaction is not all rainbows and unicorns. You will probably incur some set up or transaction fees to gain access to your funds. These fees typically run under $100, but could be more depending on your plan, so make sure the amount you take out will be enough to satisfy your needs.
Long Term Effects
Also, the funds taken will have some longer term effects you should be aware of… Funds taken miss out on growth opportunity, so in a rising market, your loss may outweigh the gains.
Employment Security
Before gaining access to your retirement funds this way, ensure your employment is secure. Does your company change contracts every few years? Then this may not be a viable option for you. Here’s why-
If you lose your job, some plans may require you to pay the outstanding balance in an accelerated amount of time. Some companies give you anywhere from 30-120 days to pay back the remaining balance…others do not. The remaining balance ends up being coded as a taxable distribution, and if you have not reach age 59 ½ yet, you will get hit with a 10% penalty as well.
...So, Maybe
In an emergency situation, knowing you can access your retirement funds is reassuring. Before doing a flat out distribution from your 401(k), borrowing from it definitely makes sense. However, weigh the benefits against the odds. Transaction fees and the potential loss of growth over the term of the loan may be a larger disadvantage than you realize.
Michelle Kuehner is a Registered Investment Advisor Representative and Managing Director for Personal Money Planning. She is also a Certified Credit Counselor, Certified Financial Health Counselor, writes Fix Our Budget blog, and has over 23 years of experience in the financial industry.
Michelle Kuehner is a Registered Investment Advisor Representative and Managing Director for Personal Money Planning. She is also a Certified Credit Counselor, Certified Financial Health Counselor, writes Fix Our Budget blog, and has over 23 years of experience in the financial industry.
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