Taking Out a 401(k) Loan? What You Should Know

By Alert Investor Markets Fool.com

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If you needed to borrow cash, where would you go? A bank? Apeer-to-peer lending platform? A payday lender? A relative?

Miranda, who lives just outside Cleveland, Ohio, chose to go to a different source of funding: a 401(k) account. She and her husband researched borrowing options for nearly a year before deciding to borrow $20,000 from his 401(k) account to fund a down payment on a new home.

"We really liked the fact that we could do this on our own without owing someone else for such a big favor," she said.

And she's not alone. Arecent surveyof more than 27,000 people by the FINRA Investor Education Foundation found that 13% had taken out loans from their retirement accounts.

"Folks in this case act as their own bank and benefit from the repayment to themselves," said Brent Neiser, senior director of strategic programs and alliances at the National Endowment for Financial Education. Neiser added that the option of taking a 401(k) loan may make some workers more likely to participate in a 401(k) plan in the first place.

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But he and other experts warn that borrowing from your 401(k) is not without financial consequences.

Among them: Even a temporary drop in your retirement account balance stops you from taking full advantage of the power of compounding -- that is, earning interest on previous interest payments -- and that's a move that could cost you thousands of dollars in future earnings.

A survey by Fidelity in 2011 found that nearly two in five retirees who had taken 401(k) loans before retirement eventually regretted doing so.

So if you are considering taking out a 401(k) loan, here are a few other things to consider to ensure you don't make a decision that you later regret.

You will be charged interest on the loan
The interest payments will be added back into your 401(k) account since you are, after all, essentially borrowing from yourself, but you will be paying interest nonetheless.

Some people, particularly those with lower credit scores, may find that the interest rates they receive on 401(k) loans are lower than those offered for bank loans.

There is a limit to how much you can borrow -- and for how long
The IRS limits 401(k) loans to $50,000 or half of your balance, whichever is smaller. For example, if you have $60,000 in your 401(k), the most you can borrow is $30,000.

Theloan termcan't be more than five years, and payments must be made at least quarterly, unless you are using the loan for the purchase of your main residence, in which case the repayment period can be up to 30 years.

You may need to temporarily stop contributing to your 401(k)
Depending on your employer's 401(k) rules, you may be prohibited from contributing to your 401(k) so long as the loan is outstanding.

Pausing regular contributions to your retirement account means that not only will you lose the opportunity to increase your 401(k) balance, but you also may be leaving "free" money on the table as well, if it means missing out on anemployer match. On top of that, you won't benefit from dollar-cost averaging, a strategy that can help investors reduce risk. (Learn more about dollar-cost averaginghere.)

The money you'll use for loan repayments will be taxed
The tax advantage of a traditional 401(k) is that the money you contribute to the account is not taxed at the time of the contribution. However, those who borrow from their 401(k) accounts must repay their loans with after-tax dollars. Then, when they withdraw their funds for retirement purposes, those funds -- including the money spent on loan repayments -- are also taxed, presenting a double-whammy of sorts.

Losing your job may trigger prompt repayment
If you lose or quit your job while still repaying a 401(k) loan, you may have just 60 days to repay the outstanding balance. That could present a bind if you don't have the resources available to you.

If you default on the loan, it will cost you
If you fail to repay your loan, the outstanding balance will be considered a withdrawal and will be subject to income tax liability. If you're younger than 59-1/2, you could also be hit with the 10% tax penalty applied to early retirement-account withdrawals.

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