Naturally, taking a loan from your 401K seems like the most sensible option when you’re in a pinch and need some quick cash. It’s your money, after all, right? While this is true, borrowing from your 401K isn’t as straightforward as it may seem. There are many caveats to doing so, and consequences that could come along if this is done incorrectly. To help you in deciding on whether or not you should borrow from your 401K, we’ve compiled a list of pros and cons below as provided by Ubiquity, a leading savings plan provider.
Benefits of Borrowing from Your 401K
Taking out a loan from your 401K is not something you should just do on the fly. This is something that requires an abundance of consideration beforehand, as it can have lasting consequences for your future finances. Still, that’s not to say that it’s not a better option than a traditional loan for those that truly need it. Some benefits of borrowing a 401K loan include:
No application process. Since the 401K is in your name and you have already been making contributions to it, the provider already has your personal information. There would be no need for you to apply.
No minimum credit score. Since you won’t need to apply for the new loan, there are no requirements for a minimum credit score. Additionally, the 401K is supplied by contributions automatically withdrawn from your paycheck, so there are no economic filtering mechanisms required to determine whether you’ll be able to pay it back or not.
Loan repayment made easy. You won’t have to do too much work to pay the loan back. Instead of having to manage a unique account for your loan, the payments will come directly from your paycheck over a maximum of five years.
Drawbacks of Taking Out a 401K Loan
These benefits are extremely appealing and make it clear why so many people consider taking a loan from their 401K. To many, the process is much more straightforward than it would be with any other loan, so this may often be their first choice. Still, there are important disadvantages to consider:
Repayments with interest. All repayments you will be making are made with the after-tax funds. This may not seem like a pressing matter, however, you must realize that this money is being paid to an account for which taxes are deferred. Once you retire, your distribution is regarded as a taxable event. Your 401K will then be charged twice since this taxation includes your loan repayments.
Possibility of defaulting. Defaulting on a 401K loan is markedly different from defaulting on a traditional loan. If you were to cancel your 401K for any reason (for example, you may change employers), your outstanding loan balance is due immediately. If for some reason you cannot pay, the principal balancewill be determined to be a distribution and becomes taxable.
Borrowing from your 401K loan is not as black and white as you may think. If anything were to go wrong, you could wind up in big trouble. Think carefully through these pros and cons to determine if taking out a 401K loan is right for you.