If you’re faced with an unexpected financial situation or you suddenly need cash, one option may be to consider taking a loan from your 401(k).  And, you’re not alone.  According to a study by the Employee Benefits Research Institute (EBRI), nearly 20 per cent of all 401(k) participants had plan loans outstanding.

However, you should think carefully before taking a loan out against your retirement savings.  What are the loan limits?  What are the advantages of borrowing against your 401k?  And what should you be aware of?  We answer all these questions here.

How does a 401k loan work?

When you take a 401(k) loan, you specify the investment account(s) from which you want to borrow money.  Those investments are liquidated for the duration of the loan.

You lose any positive earnings that would have been produced by those investments for the period of the loan. The upside is that you also avoid any investment losses on this money.

2 Things You Need To Know About a 401k Loan

If you’re considering taking out a loan against your 401k, there are two things you should know.

Firstly, there are limits to the amount you can borrow.  In general, you can borrow the lesser of $50,000 or one-half of your retirement plan balance. For example, if your 401k balance is $200,000, you could only borrow $50,000, not half of your plan balance.

To accept the loan, you must typically agree to begin paying back the loan during your next pay period.  Most often, this is done via an automatic deduction from your paycheck.

Secondly, unless you use the money from your 401k loan to buy a home, you must pay the loan back within five years.  If you borrow the money so you can purchase a residence, the length of the loan may be significantly longer.

There are some situations where it can pay to borrow against your 401k plan, as we see next.

Advantages of borrowing against your 401k

One reason that many people turn to a 401k loan is that it can be arranged quickly and easily.  You won’t generally have to go through a lengthy application process or any credit checks and you can often have your cash in just a few days.

In addition, although regulations say that your loan should be repaid within five years most 401(k) loans allow you to repay the plan loan faster with no prepayment penalty.  Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement.

Another reason to consider a 401k loan is that the fees for arranging such a loan tend to be modest.  You may pay a small administration fee but there are no significant fees and charges.

Finally, a 401k loan can actually benefit your retirement savings.  As you make loan repayments to your 401(k) account, they usually are allocated back into the investments that you have chosen.  You repay a bit more to your account than you borrowed from it in the form of interest.

If any lost investment earnings during the period of the loan match the interest paid in, there will be no impact on the value of your 401k plan.   If the interest paid in exceeds any lost investment earnings, taking a 401(k) loan actually can increase the value of your retirement fund.

You effectively pay the interest to yourself, in the form of boosting your retirement fund.

While there are many benefits to taking out a 401k loan, there are also some disadvantages, as we see next.

Disadvantages of borrowing against your 401k

It is important that you understand the reasons why many financial experts advise against taking a loan from your 401(k).  Many people believe that a 401k loan should be your last resort as there are some disadvantages to a 401k loan.

For example, there are various tax implications of a 401k loan.  As you pass-up the tax-free compounding of the money you withdraw, you could end up with a significantly smaller fund on your retirement.  And, interest payments from a 401(k) loan are not tax deductible.

You will also pay taxes twice on the amount you took out for a loan.  Your 401k loan payments are deducted after taxes have been taken out of your paycheck.  However, since pre-tax money is usually used to fund a loan, the payments are put back into your 401(k) as pre-tax funds. This means that when you take the money out later, you will have to pay taxes on it again.

In addition, you could face the potential of defaulting on your loan. If you lose your job or if you decide to leave your employer, you will be required to pay off the loan in a lump sum.  If you don’t, you face the potential of the loan defaulting, which will result in a taxable event.

Finally, there is no flexibility with the terms of repayment and your loan repayment is done automatically through payroll deductions, which will reduce your take-home pay.

Should you take out a 401k loan?

Life is unpredictable and you could easily be left in a situation where you need a quick injection of cash.  So, taking a 401k loan could be your only solution.

Before you take out a 401k loan, it’s vital that you explore other options.  Using savings or other types of loan may be a more suitable alternative to borrowing against your retirement funds.  You should be careful not to jeopardise your retirement just for a quick cash fix now.