Photo (cc) by ToGa Wanderings
Don’t do it!
That’s the conventional wisdom about taking out a 401(k) loan. And as someone who took out one, left her job and found herself shelling out big bucks in taxes and penalties, I’m not about to argue with conventional wisdom.
However, people stretched financially thin may think otherwise. They may see their 401(k) account as a tempting source of cash. To help those of you thinking about dipping into your account, we want to take a moment to review what you need to know about these loans. I also contacted two Certified Financial Planners so you wouldn’t have to take my word for it.
I fully expected both planners to say 401(k) loans are nothing but bad news, and certainly, they both expressed extreme concern about people dipping into their retirement savings. But I was also surprised to hear that a 401(k) loan may make sense in some limited situations. Before we get to those, let’s start with the basics of 401(k) loans.
Basics of 401(k) loans
Named after a section of the tax code, traditional 401(k) plans allow you to put money aside, tax-free, for retirement. After a few years of regular contributions, these plans can carry a nice balance, which may start to look like a handy cash cow.
While there is no requirement that 401(k) plans allow loans, many do. Under IRS rules, those that do allow loans can let participants take out up to 50 percent of their vested account balance, or $50,000, whichever is less. Typically, these loans are paid back over a maximum of five years, although, in some cases, a longer payback period may be arranged. On occasion, the IRS issues special rules, such as after hurricanes Katrina, Rita and Wilma when those affected were allowed to take loans for their entire vested balance.
Loans from 401(k) accounts do charge an interest rate, but that money is paid back into the plan. This is one reason they may appeal to some workers. Rather than paying interest to a bank or other lender, the worker keeps the interest to pad their retirement account. In addition, repayments are made via a payroll deduction, which makes them convenient, another bonus for some workers.
Why they aren’t such a hot idea
Despite being an apparent source of easy cash, some finance experts say you should be keeping your hands off your 401(k).
“Your 401(k) is not a savings account,” says Mark Vandevelde, a CFP and wealth partner with Hefty Wealth Partners in Auburn, Ind. “It is money that should be set aside for long-term goals and never to be touched, in my humble opinion.”