Money Minute: What happens when you take out a 401(k) loan? Yahoo Finance Monday, July 13, 2015
If you've ever been tempted to borrow money from your 401(k), you're not alone — one in three American workers admit to borrowing from their 401(k).
After all, when you're in a pinch and need cash for an emergency, it seems only logical that you should be able to borrow from your own retirement fund. It's your money, right?
But know this: borrowing from your 401(k) is pretty much like going into the future and stealing money from your own pocket. For that reason, regulators make it awfully expensive to do.
Fees, fees and more fees. One of the biggest risks with 401(k) loans is the chance that you might not be able to pay them off. If you start missing payments, you will get slapped with fees. First, you will be charged income taxes on that loan and secondly, you could get hit with an early withdrawal penalty. Let’s say you fall behind on a $10,000 loan to pay off some credit card debt and you’re in the 25% income tax bracket. You’ll have to pay $2,500 to cover income taxes on that loan. On top of that, if you’re younger than 59 and a half, you’ll pay
an extra 10% or $1,000 in early withdrawal fees.
What if you lose your job? You have to repay the entire loan back in 60 days or less. That’s easier said than done when you’re out of work. More than 80% of workers who take out 401(k) loans and leave their jobs eventually go into default. If you can’t cover it, you’ll get hit with a 10% penalty plus income taxes.
A hardship withdrawal: If you are in dire need of money (for example, you're hit with major medical bills or you need to over funeral costs for a relative) and can't afford to pay back a 401(k) loan, you can ask for a hardship withdrawal. Hardship withdrawals are subject to all the same taxes and early withdrawal feees as a regular 401(k) loan, but you aren't required to pay them back. The downside is that you are blocked from paying any money back into your retirement fund for six months.
And the biggest risk of all? You’ll be missing out on all the gains you could have earned if you’d just left your 401k alone.
Correction: An earlier version of this article left out an important fact about 401(k) loan fees -- the fees only apply if you fail to pay back your loan on time. It has been updated to reflect this change.