If you participate in your employer's 401(k) plan, find out if it allows you to take loans against your account balance. Many 401(k) plans allow loans. But remember... this is a retirement fund first and foremost. We always recommend that you save for your retirement first. It is the single largest commitment you have to fund—even bigger than the purchase of a home. So if you are going to borrow from a 401(k) plan, do it knowing that it could get in the way of your retirement plans. See the section 401(k) Loans to learn more.
Consider All Available Options
Most 401(k) plans offer loans. Instead of withdrawing your savings from the 401(k) plan, you can borrow from your own 401(k) plan account. Loans are not considered withdrawals by the IRS, so your loan amount is not taxable, and you don't pay the 10% early withdrawal penalty. Loan terms are no more than five years for general purpose loans. Home acquisition loans generally have a longer loan term (which will be specified in the plan document). Loans must be paid back on a regular basis; it may be quarterly, monthly, or biweekly, but it will be at least once each quarter.
Since your loan is secured by your 401(k) plan, Department of Labor rules won't let you borrow more than 50% of your account balance. There are also certain tax rules that limit the amount you may take as a loan without it being considered a taxable distribution. Under current tax law, a 401(k) plan can permit you to borrow as much as $50,000 or half of your vested benefits in the 401(k) account, whichever is less. If your vested account balance is at least $10,000, you can borrow up to $10,000 even if 50% of your vested account balance is less than $10,000. If your vested 401(k) plan account is less than $10,000, you can borrow up to your vested account balance. The $50,000 amount is reduced by the highest balance of any loan you had in the previous 12 months, even if you've paid it off.
Of course, a specific employer's 401(k) plan does not have to permit loans this large. Also, many plans have a minimum amount you can borrow, usually $500 or more.
401(k) plans are required to charge interest on a loan at the going rate for interest on similar loans in the community. Reasonable rates range from the prime rate plus 1% to a certificate of deposit rate (CD) plus 2%.
Determine the True Cost of Borrowing
What does it really cost you when you borrow from a 401(k) plan?
When you borrow from a 401(k) plan, you no longer earn investment returns on the amount you borrow from the account. In effect, that money is no longer in the 401(k) plan earning money; you've borrowed it, and it is out doing something else. So, although the interest you pay on the loan goes back into your 401(k) account, the true cost of the loan is the amount you would have earned on that money had you not borrowed it from the account. It is what we call opportunity cost: you're missing out on the opportunity to earn money on those investments, if you hadn't borrowed funds from them—and it is a tricky concept. Don't fall for those pitches that "you're paying yourself back." That's not all that's happening—you're also missing out on the investment earnings on those funds that were borrowed.
On the other hand, borrowing from a 401(k) plan can work to your advantage if the market is losing money. By pulling the money out as a loan, you're not participating in a losing market.
To summarize, not participating in 401(k) investments can work to your advantage or disadvantage, depending on the investment performance over the term of the 401(k) loan.