Should I Borrow From my 401K?

This has been a common question for the past five years. There are many things to keep in mind when you consider whether to borrow or withdraw money from your 401K, such as penalties, taxes and the “set back” to your retirement account.

Borrow

You can borrow up to $50K or 50% of the amount in your 401K but you must pay it back within five years. You must be employed and contributing to a plan to do so and the payment comes out of your paycheck.

Advantages

  • Competitive interest rate – prime + 1%
  • No credit check
  • Application fee can be free or up to 15%
  • Your pay yourself interest, not the bank
  • Proceeds not taxed unless you default

Disadvantages

  • Borrowed amount will not be invested for retirement until paid back
  • Opportunity lost in no growth of that investment for five years
  • Pay back with after tax dollars but were  invested as pre-tax
  • Pay taxes on the proceeds, if default
  • Pay income tax again on the money when withdraw at retirement
  • If lose your job or switch companies, must pay the loan off in 60 days. If can’t, considered a distribution and pay income taxes on outstanding amount plus 10% penalty if under 59.5 years old.

Early Withdrawal

Early withdrawal from your 401K prior to age 59 1/2 is allowed under a hardship exception. It is not considered a hardship if you or family members have other financial resources. You cannot repay the withdrawal from the plan and you are usually not permitted to contribute to the plan for six months after the withdrawal.

Financial hardship

Since the financial hardship is an early withdrawal, it is subject to income tax plus a 10% early withdrawal tax. For example, if you withdraw $10,000 and are in the 28% tax bracket, income tax is $2,800 and penalty is $1,000. This leaves $6,200 to spend after taxes and you paid a tax rate of 38%.

The distribution can be used for:

  • Payment needed to prevent eviction from, or foreclosure on, your principal residence.
  • Certain medical expenses
  • Burial or funeral expenses
  • Cost of repairing damage to your principal residence
  • Cost of purchasing your principal residence
  • Tuition and related educational fees and expenses

Non-financial hardship

In a non-financial hardship, you still pay taxes but the 10% penalty fee is waived. To qualify for a non-financial hardship, you must meet any of the following:

  • Pay for Medical expenses exceeding 7.5% of your adjusted gross income
  • Death or disability of the plan participant
  • Age 55 or older and are retired or left job
  • Distribution is part of equal payments over lifetime
  • Required by a divorce decree or separation agreement

I don’t recommend taking an early withdrawal or borrowing from your 401K. This depletes your retirement account and is very risky. Early withdrawal is the worst scenario, because you pay income taxes and an additional 10% penalty. You can only borrow from your 401K if you have a job, but if you lose it, you have to pay the loan in 60 days. It is better to find another alternative.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a Contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry.  Follow him on Twitter here.

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