Is It Wise To Borrow From Your 401(k) Plan?

There can always be a temptation to borrow from your own 401(k) funds. However, it may not always be prudent to do so. Whether one should borrow or not depends upon many factors, but before that, one should be fully aware of all the pros and cons of the decision. With due diligence, the option to borrow from 401(k) is a significant asset, but can be liability in the absence of it.
Is it Wise to Borrow From Your 401(K) Plan?
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Borrowing from 401 (k) Plans

Whether borrowing from your 401 (k) plan is a wise decision or not depends upon your circumstances, but it can often be a wise decision provided you have considered all the pros and cons of such borrowing, know how to plan for it and are able to repay it in time.

First know all the details of your 401(k) plan

The primary purpose of 401(k) plan is to plan for your post-retirement life. In addition it also provides you certain tax benefits and often a matching contribution from your employer. Before deciding to borrow, you must know

all about the terms and conditions. While doing so, make note of the following factors.

  1. First of all confirm the availability of borrowing option. Next, find out the maximum amount you can borrow. Usually, it is an amount that is lesser of 50% of your vested balance in the 401(k) plan or $50,000. Compare this will your actual need. Borrowing from 401(k) would be worth only if it able to sort out the credit crunch you are facing.

  2. Ensure the time limit for repaying loan. Usually the maximum time limit allowed for repaying this loan is up to five years, except in the case you need it for your first home mortgage, when it is up to fifteen years. Try to assess your overall financial position and future obligations and see whether you would be able to make the full repayment in prescribed time. This can have significant impact because if you are unable to repay the loan in prescribed time, your borrowing will be treated as a premature withdrawal and attract income tax as well as a penalty of 10% on the amount borrowed.

  3. Take in to account any matching contribution from your employer in your calculations. If there is a provision of a matching contribution from the employer, then it would be usually preferable to continue with making contributions even during the period of repayment of an earlier loan, in case terms and conditions of your plan allow for that. In case this is not allowed, or if you may not be in a position to make fresh contributions during repayment, then the actual cost of borrowing will be higher than the rate of interest.

Compare all the options for borrowing

One must always remember that 401(k) plans are meant primarily for a purpose other than tapping into for debt. Thus, other more regular option for borrowing must always be considered, including paying your taxes in instalments. However, in case your credit worthiness does not allow you to take credit from financial entities, or the only options available are high risk, high cost ones like a credit card, or if they do not allow you enough time to save and repay, then borrowing from your 401(k) plan could be a very sensible step.

Advantages of borrowing from 401 (K) plan

  1. Getting the loan from your 401


    (k) plan is usually a simple and expedient process, not requiring cumbersome formalities or procedures. You can get the loan irrespective of your past credit rating.

  2. The interest rate charged is usually low compared to other credits.

  3. So far as you pay it back, there are no taxes or penalties for borrowing.

Disadvantages of borrowing from 401 (K) plan

  1. Borrowing from 401(k) restricts your earnings to the interest paid by you and if you cannot make contributions you may lose out on matching contributions of your employer. In addition, it can disturb your whole retirement planning.

  2. There is always a danger of not being able to repay within the stipulated time, leading to imposition of income tax and an early withdrawal penalty of up to 10%. Even in case you lose your job you would most likely be required to repay the debt within 60 days failing which it may be considered as an early withdrawal with all its adverse consequences.

Take a decision after analyzing all the factors

Once you are aware of all the relevant factors, you can take a decision regarding borrowing from your 401(k) plan. You must also assess the need for borrowing. Casual borrowing for a consumer durable which is not exactly unavoidable may not be a wise step, however, borrowing to keep off loan sharks, or to buy a house would always be worth it, as would also be occasional borrowing of a manageable amount to repay very high interest credits as in the case of a credit card. While taking this decision, you need to be reasonably assured about not likely of losing your job, or shifting it to some other employer, as well as your future incomes and repayment capacity. It is also worth remembering that funds in retirement plans are comparatively safe from pending debt claims.

A wise decision

A wise decision to borrow from 401(k) plan would be one where there is no marching grant, the need for funds is absolutely unavoidable, other credit options are either not available or costing a very high rate of interest, and you are reasonable assured about the continuity of your career till the time the amount borrowed from 401(k) plan is repaid. It would be even wiser if you are replacing the safety of your retirement plan with a house property being purchased with funds borrowed from 401(k) plan.

For borrowing from a 401(k) plan, wisdome practically means due diligence!
 



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