Advantages of a 401(k) Loan
The biggest advantage of a 401(k) loan is that you are both the borrower and the lender, so you are paying yourself with interest. If you have to take out a loan, it’s better than having to pay anyone else. 401(k) loans are typically offered at very competitive interest rates. Interest rates are usually tied to the prime interest rate and can be significantly lower than other forms of debt like credit cards or personal loans. The interest you pay to yourself is tax-deductible and you won’t pay taxes on it until the 401(k) is distributed after retirement.
Many of the loan application fees and processing costs that can increase your loan debt are bypassed (note: fees may vary so it’s important to check twice to see if there are any application fees). You need to apply, but you’re unlikely to be denied and you can access your funds relatively quickly. These loans have little to no restrictions and credit checks are not required. (And defaulting on this type of loan does not have the same credit impact that it would on a traditional loan.)
Limits and Restrictions of a 401(k) Loan
Individuals are usually allowed to borrow 50% of their 401(k) account balance up to a maximum of $50,000. There may also be a minimum threshold of around $1,000. The terms of 401(k) loans are typically up to five years or less; the only exception would be if you are using the money to purchase a home, in which case you may be granted a longer repayment period. As a 401(k) account holder, you can designate which assets you wish to liquidate to borrow from, so you may be able to borrow funds without touching your best-performing investments. Your account administrator can give you an idea of the specific limits and restrictions for your account.
Disadvantages of a 401(k) Loan
There are two main disadvantages to a 401(k) loan. The first disadvantage is that you are using money that would have been working for you. It’s an opportunity cost because you miss out on potential growth. (But honestly, you could also miss out on a bad market, which could be a good thing.) Sure, you are earning interest as the lender, but it’s not at a high-interest rate.
The second disadvantage is the likelihood of default. Historically, if you lose or leave your job, many plans may require you to repay the loan within 60 days. After that, it will be considered a distribution from your 401(k). You are likely to owe taxes on the money, plus (if you are under 59 and a half) a 10% penalty fee. Imagine a scenario where you are suddenly laid off and forced to choose between a huge loan payment or a huge tax bill. This can easily happen if you took a 401(k) loan.
There are some exceptions to early withdrawal penalties from 401(k). 401(k) loans became less risky with the new tax law. When leaving an employer, you now have until the due date of your tax return (including extensions) to return the money to your 401(k), or IRA, or a retirement plan at a new employer.
Note: The CARES Act allowed for the suspension of 401(k) loan repayments for up to one year for loans due from March 27, 2020, to December 31, 2020.
Should You Take a 401(k) Loan?
The bottom line is that you need your 401(k) to bolster a secure retirement. Anything that puts that at risk should be carefully considered. If the only other option you have is to withdraw money from your 401(k) entirely, then the loan is the better choice. However, if you have any other options, just leave the 401(k) alone.
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Source: https://www.thebalancemoney.com/401k-loan-pros-and-cons-2894188
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