What Is A 401K Loan?

What is a 401k loan? All 401k plans by law, must allow you to borrow money from them, and this is often easy and therefore tempting to do. A 401k loan is simply what it sounds - a loan against the current...

A 401k loan is simply what it sounds - a loan against the current amount in your plan. All 401k plans by law, must allow you to borrow money from them, and this is often easy and therefore tempting to do. In fact the loan opportunities of most 401(k) plans are often presented as a selling point to encourage more employees to participate in retirement plans that offer major tax advantages. However, employers are not actually required to allow 401k loans - many smaller employers simply can't afford to offer this feature to employees.


It is not always a good idea from a financial point of view to borrow from your 401k account. If you are a homeowner it is usually a better idea to take out a home equity loan rather than borrow from your 401k. However, investment analyst Paul Dlouhy makes the point that "Borrowing from your 401k is nearly always going to be a better idea than putting money on a high interest credit card, or taking out other high interest loans".




One disadvantage is that it is fairly easy and tempting to borrow money from your 401k loan - especially if you are a long way from retirement. After all, younger workers naturally feel that they won't really need the money for some time. Younger employees particularly like the idea of being able to borrow money easily and statistics show that some people only participate in the plan to begin with as it may be an easy way to borrow money. You can also choose exactly where the money comes from for your loan - don't borrow money from those investments which are performing well.

There are no restrictions as to what the money from a 401k loan may or may not be used for - many people use the money for wedding expenses, car payments, home improvements. Many employers will only allow a loan for what they deem a legitimate reason - first time home purchase, to avoid eviction, medical or college expenses. A 401k loan will not show up on your credit report.

Warns Dlouhy on the subject of loans "Some 401k loans have a minimum amount you can borrow - often $1000 - and you are generally allowed to borrow a maximum of 50% of your balance up to a maximum of $50,000". Loan payments can be conveniently deducted from a paycheck in much the same way the 401k contribution was deducted.

Tax advisor Dlouhy points out some of the disadvantages with a 401k loan "If you do borrow money from your 401k, you lose out on any employer matching contributions while you are paying off the loan; you also potentially lose out on any profits to be made on your investments." Says Dlouhy "Some 401k plans will not allow you to make any new contributions until the loan from the plan has been paid back in full." If you stop working or switch employers, the loan must be paid back immediately. There may also be an administrative charge or other fees applicable to take out a loan from your 401k plan, apart from the paperwork involved.

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