In an ideal world, it never makes sense to borrow from your 401k account. However, in the real world, there are times when it is necessary (especially in Covid pandemic times). Surprisingly, it can be a relatively cheap way to borrow money.
If you’re considering a 401k loan, the first thing you have to do is make sure they are available in your plan. Most offer loans but it is not required.
Recent legislation, known as the CARES Act, has changed some of the rules when borrowing from your 401k. These changes have made 401k loans even more appealing, compared to other sources when cash is needed. The following incorporates those updates:
If your plan allows loans, here are the basics:
- You can borrow up to 100% of your account value, with a maximum dollar value of $100,000.
- You can wait up to 1 year to start paying back the loan.
- You have up to 5 years to pay back the loan. Actually 6 years, if you defer payments 1 year.
- Loan payments are deducted directly out of your paycheck.
- The interest rate is typically the prime rate at the time the loan is taken out. Currently, the prime rate is 3.25%.
- Your spouse has to sign off on the loan as well.
- If you quit or lose your job, the loan has to be repaid in full or it will be considered a distribution, which is subject to taxes and penalties.
When you take a 401k loan, you are borrowing from yourself. Essentially, you are trading stock market returns for a fixed interest rate (the loan rate). If the market tanks while you have a loan out, you’ll look like an investment genius. Usually though, there is an opportunity cost on that loan amount. For example, if you didn’t take a 401k loan, that money would be invested in the stock market. The opportunity cost is the difference between what your stock market fund in your 401k returns and what the loan interest rate is.
I think there are certain situations where taking a loan out on your 401k makes sense. If you have high interest debt, say credit card debt with an interest rate of 20%, taking a 401k loan with a rate around 5% to pay off that credit card debt is a sound financial move.
Having said that, this isn’t a one-size-fits-all solution. Your financial situation and your 401k plan are unique to you, so crunch the numbers to make sure it makes sense before pulling the trigger.
Let me know if you have any questions.
Joe Baker, CFP®
Baker Asset Management, LLC
joebaker@bakerassetmanagement.com
