A lot of financial advisors and pundits say “Don’t borrow from your 401(k)” but I say maybe you should.
First, know the rules which are set by the IRS for loans and withdrawals from deferred income accounts like 401k and IRAs.
401k loans come in 2 types:
> The 5 year payback and
> The 10 year payback.
The 10 year loan is only available when you’re purchasing a primary dwelling. The 5 year loan can be used for almost anything.
Now, we all know that into (almost) every life a crisis or 2 will come and those usually require cash. But, unless you’re pretty sure you’ll be dead without the money, your 401k loan is not the place to get emergency cash. You should have a fund or credit for that.
First off, it’s going to take anywhere from a few days to weeks to get the loan – your employer and the company they’ve contracted with to manage your account set-up the loan procedures (adhering to IRS rules). They’re not real keen on reducing the amount of money they have under management so they don’t make processing loans a top priority.
And some small employers just don’t have loans available at all (it’s optional when they set-up the 401k plan); most claim it’s too expensive to administer. You should also expect to pay a small fee for the loan processing if your employer allows them.
And then there is the fact that unless you’re going to invest the money in something that pays more than your 401k investments, you’re missing out on the returns and compounding the returns while the loan is outstanding. You’ll also have to agree to make monthly repayments so your net paycheck will shrink.
On the plus side, the interest on the loan goes into your account – you pay yourself back with interest. And that is why I don’t say 401k loans are always such a bad thing!
If you’re almost positive you’ll have your job for the next 5 or 10 years and you’ll reduce your monthly expenses to accommodate the repayment, then paying your 401k interest can be a win for you.
There are even stories about people using the lower interest 401k loan to pay-off higher interest rate debts (like student loans). So, they’re using the 401k loan to become debt-free a lot faster than making the standard loan payment (and remember, the interest goes into your 401k account).
If you use the loan to make a higher rate of return — maybe a new side business or unconventional investment like peer-to-peer lending — a 401k loan can end up being doubly profitable.
If you’re buying a new home, taking the 10 year loan to use as part of the down-payment may get you a lower interest rate on the mortgage. Plus, the interest you pay yourself (your 401k actually) IS tax deductible just like all your other mortgage interest. You won’t get a 1098 but you can collect the payment data and report it as other interest on your schedule A.
This also allows you to diversify out of the financial markets into the real estate sector. I’ve used this several times to finance a house, live in it for a couple years and then convert it to a rental. The interest I repay my 401k is then a deduction against the income from the house.
Being smart and informed about your options for using 401k loans is part of being a savvy investor. So don’t let a “guru” tell you “Never borrow from your 401k” – you decide if it’s a smart move.
Live long and prosper, Leah the MoneyDiva.com