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Borrowing from your 401(k): Advantages and Disadvantages

With today’s companies getting rid of pensions 401(k)s have become one of the primary ways, for most individuals, to save for retirement.

Most 401(k)s are pretty flexible in that in they allow you to borrow against them.  But before you run off and cash out your nest egg, there are some advantages and disadvantages that you should be aware of:

Advantages

  • You can borrow up to $50,000 or ½ of your plan balance.
  • The loan payment is usually automatically withdrawn from your paycheck, which makes it very easy to pay back.
  •  No credit check is required since you’re actually borrowing from yourself.  This works out well if you have poor credit.
  • You’ll pay a pretty competitive rate on the loan but the good thing is that you will be paying this back to yourself.
  • Little to no administration fees involved.

Disadvantages

  • You’re borrowing from future money reserved for retirement which makes it harder for your money to grow.  The longer your money is outstanding from your 401(k) plan the longer you forgo all potential investment gains from all borrowed funds for the duration of your 401(k) loan.
  • If for some reason you are not able to repay the loan back, such as the loss of a job, then you will trigger a tax bill (federal/state taxes) as well as pay an additional 10% penalty for early distribution.

You should be cautious when borrowing from your 401(k) as it defeats the purpose of saving for retirement.  Only borrow from your plan if it is an emergency and you’ve exhausted all other avenues.