According to a recent report by Aon Hewitt, about one quarter of 401(k) participants have an outstanding 401(k) loan. Many people are left wondering how these loans work.
Carl Carlson, CEO of Carlson Financial said most 401(k) plans allow the participants to borrow up to half of their vested 401(k) balance, up to $50,000 total. The participant is technically borrowing from themselves, but they do have to pay it back with a reasonable rate of interest, which is set by the plan administrator.
There might be a lot of reasons someone might want or need to borrow money before retirement. but it depends on the person.
Carlson said for most people, it should be used as a last resort and there are a few reasons why:
- By taking money out of the 401(k), borrowers miss out on any compounded growth they otherwise may have gotten – this could be a big setback to retirement savings.
- Another downside people often don’t realize, is the loan is repaid with after-tax dollars. So for someone in the 24% tax bracket, they will need $124 to repay $100 loan.
- It may also be risky because if the borrower leaves that job for whatever reason, they typically have 60 days to pay off the loan, otherwise it will be counted as a taxable distribution with a 10% penalty for those under 59.5.
Carlson said he would only recommend borrowing from a 401(k) in limited situations.
One would be if you knew you were going to be able to pay it back in a short period of time, say a year or less. Another would be as an alternative to other high-interest debt, like a credit card or payday loan.
401(k) loans may be more attractive to people with low credit because it doesn’t involve a credit check and the interest rate is probably lower than what they could get otherwise, Carlson said.
It becomes problematic when people use it more like a checking account and in that case, though more difficult, they might need to make a lifestyle adjustment.