“Never, ever, ever resort to borrowing from 401k funds. Ever.” If you have a 401k account through your employer, you have probably heard those words over and over again. Although the option for you to take out a loan on your 401k exists, most financial advisors will tell you that taking one out is a really bad idea. After all, you are trying to use your 401k funds to secure your financial future after you retire. Some people will even tell you that taking out a 401k loan is like stealing from yourself, since you won’t be earning anything on the money you have out.
Certainly, taking out a loan on your 401k is not encouraged; however, there are some times when it’s actually okay to borrow from your 401k. In fact, a study by the Employee Benefits Research Institute (EBRI) found that 18 percent of all 401k accounts had outstanding loans in 2006. This number has only increased since that time, given the recession and slow recovery. A 401k loan doesn’t have to spell retirement disaster, if you are taking one out for the right reasons and know how it’s going to impact your nest egg savings.
The Basics of Borrowing from 401k Funds:
When you borrow from your 401k, you aren’t actually taking out a loan, since there isn’t a lender and no one is going to look at your credit report to see if you’re actually going to repay it. Essentially, borrowing from 401k funds allows you to access your retirement account and take out as much as $50,000 or 50 percent of your account’s value, whichever is less. You are required to pay yourself back within 12 months to return your 401k to its initial level.
The nicest part about this kind of loan is that it is tax free. You do not pay taxes on the amount you take out, so it is considered a tax-free cash withdrawal. In addition, you are required to pay interest fees to yourself on the amount you have borrowed. This means you are actually making money on the cash you are borrowing. This is much more attractive than taking out a traditional loan and paying interest to a bank.
Sounds pretty good, right? Well, it can be, depending on your circumstances. If you carefully manage your 401k loan, you can actually make money on the deal. However, the trap many people fall into is that they don’t pay it back. While some companies require payroll deductions to pay back the loan, if you are no longer working for that company, you are responsible for making those payments and it can become easy to default. That being said, here are four situations where borrowing from 401k funds can make sense.
Flexibility in Repayment:
It isn’t hard to pay back a 401k loan, since most plans allow five years to repay the loan if you need longer than the 12 months that will restore your 401k to its initial level. You repay your loan based on an amortization schedule as dictated by your plan. The best way to repay your 401k loan is to set up automatic payroll deductions if your company allows it. This will prevent you from defaulting on the loan unless you leave the company at some point down the line. Be sure to check your payroll statements and your 401k statements every month to ensure you have received your payment to yourself.
Just because you have five years to pay it off, though, doesn’t mean you should. You can pay your loan off with no prepayment penalties any time you want. You can simply contact the company that is managing your account and arrange for a payoff. Be sure to speak with your payroll department to stop taking out payments if you do repay your loan early.
Almost no traditional loan can get approved as quickly borrowing from 401k funds. You don’t have to wait for a credit check to come through and you don’t have to worry that it won’t come back high enough for you to be approved. This can be a very attractive feature of 401k loans for people who have poor credit and can’t get financed through traditional means.
Moreover, the process for applying for a loan is usually very easy. Most 401k companies have online applications that allow you to request a loan without ever signing an actual form. You can typically find a link to this form through your company’s human resources website. If your plan is managed by an outside company, you might have to go directly to that company’s website, log into your account and access the form that way.
The process time for a 401k loan is usually very quick. Most of the time, you will have a check in your hands within a week of applying for your loan. If you request direct deposit, the process time will be even less. If you are requesting a large sum of money and it comes to you in check form, be aware that your bank may hold the funds until the check clears, leading to a delay of three-to-five business days.
Other than the interest that you pay to yourself, borrowing from 401k funds does not cost you a dime. You do not have to worry about loan origination fees, late payment fees, early payment penalties and more. You can even specify which investment you would like your loan to come from so that you can choose the fund that does not perform as well as your others. You do lose any positive gains that might have been earned if you’d left the money there, but you are also removing any risk of losing it.
You might have been scared off of borrowing money from your 401k. While it isn’t always the right decision for investors, there is a time and place for a 401k loan. If you need cash quickly and intend it to be used for a short time, your 401k should be one of the first places you look. Don’t be afraid to use this resource for short-term financial needs.
Image courtesy of FreeDigitalPhotos.net