How Do 401K Loans Work?

401k loans are becoming more and more common. What once was thought to be untouchable money is becoming a source of income. Many people do not understand how a 401k loan works and what exactly is involved.

Advantages of 401k Loans

One reason that so many people are using 401k loans is the ability to avoid any early distribution penalties. Cashing out your 401k before you are 59 1/2 results in a 10% penalty. For example, if you take out a loan when you are 55 for $25,000, the penalty will be $2500, leaving you $22,500.

If you cash the money out of your 401k, the money becomes taxable. You can end up being taxed 46 %. A 401k loan, on the other hand, is not taxed.

In addition to avoiding penalties, you will also be paying interest to yourself. Many people hate paying interest to the bank or another lender. With a 401k loan, you are just making required payments back to your retirement. It forces you to take care of your retirement planning and pay yourself a good rate of return.

The 401k Loan Process

401k loans are a lot easier to qualify for than traditional loans. There is much less paperwork involved and the process is typically quick and simple. You are basically borrowing from yourself, so if anyone loses on a default it will be you. The process usually consists of a simple form that you have to fill out and sign.

Many plans do not allow for loans against the balance, so you will want to talk to your plan administrator about your options before you get started. Your plan will possibly have multiple options that you can decide upon. You can get your money in one lump sum, or over several payments. You will need to strongly consider the repayment options at the time of setup. Be sure to carefully determine that you can afford the payment; otherwise, you need to look at other options.

Should You Borrow?

Determining whether or not you should consider 401k loans is the most important factor. Typically you should have a very good reason to borrow against your retirement and borrowing against your savings should only be considered after serious thought and consideration.

Do not borrow against your retirement for a dream vacation or upgrading your house. Be sure that the borrowing is only for emergencies. If you are unable to repay the loan for some reason, your retirement years will suffer greatly due to loss of income.

When compared to a pension plan or an IRA, 401ks have several distinctive factors that make them a good investment. The ability to borrow against the money can be attractive; as long as you make sure that you are doing it for the right reasons.


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