Does borrowing from your 401K make sense?

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Borrowing from your 401K may seem tempting, especially if your employer permits...

Borrowing from your 401K may seem tempting, especially if your employer permits low-interest loans against your retirement savings. But before you sign on the dotted line and remove money from your nest egg, ask yourself the following questions to make sure you understand all the financial and legal ramifications of a 401K loan.

Does my employer allow 401K loans?

Your first step in the 401K loan process should be a call to your company's benefits department. Although employers are allowed to offer 401K loans, they are not required to do so. Many companies also have an initial vesting period during which you may not take money out of your 401K for loan purposes.

How much can I borrow?

If your employer does offer 401K loans, the limits are usually 50 percent of your vested amount up to a maximum of $50,000. Depending on the vested amount in your 401K, the loan amount for which you qualify may not even be as much as you need to borrow.

How much time do I have to repay the loan?

After borrowing from your 401K, a loan must be repaid within five years unless the funds are used to purchase your primary residence. You must make continuous payments while the loan is outstanding, generally monthly or quarterly. Often, employers will subtract the loan repayment amounts right from your paycheck.

How stable is my job?

One of the most overlooked stipulations related to 401K loans is the repayment requirement. When individuals take out loans, they rarely intend to pay them back immediately. Yet, 401K loans must be repaid in full when an individual terminates his or her employment. If repayment is not possible, the remaining portion of the loan will be taxed as an early distribution. To avoid paying tax penalties, set a plan to repay the loan in the event of a sudden job loss.

How does a 401K loan affect my long term savings?

The main financial drawback of a 401K loan is your loss of future compound earnings. Your overall balance will be lower after a loan, so you will be earning fewer dollars and building your retirement fund more slowly. Ask yourself if it's worth the extra months or years of working later on just to take out a 401K loan for the present.

For specific questions about 401K loans or alternative borrowing opportunities, consult an Atlanta-area financial advisor for help. Financial advisors can help you meet your retirement goals by setting long-term savings plans, formulating a budget and recommending an investment strategy based on your current age and income.

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