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Should You Take Out a 401(k) Loan?

Barbara Marquand | guest writer for GoTalkMoney

If you're thinking about raiding your retirement fund to buy a shiny new toy, forget it. But if you really need short-term cash and you're out of other options, then a loan from your 401(k) might make some sense.

A 401(k) loan is a bit of a misnomer. You don't have to go to a lender to get the money; it's a matter of accessing the cash that you've put into the account. But you do have to pay interest, and there are rules that govern how much money you can take out and when you have to pay it back to avoid tax penalties.

Here are the points you should know:

• Tax Considerations

A loan is not the same as an early withdrawal from a retirement plan. With an early withdrawal, you owe federal and state income taxes on the amount, along with a 10% federal tax penalty if you're under age 59 1/2. With a 401(k) loan, though, you don't have to pay taxes on the money you borrow, as long as you pay it back on time.

That doesn't mean there are no tax considerations. You'll repay the loan after taxes, and then that money will get taxed again after you retire and withdraw from the account.

• Loan Limits

Under federal regulations, you're allowed to access up to $50,000 or half the account balance, whichever is less, if your plan allows for loans, which many do. Unlike a loan you get from a lender, you don't have to explain what the money is for and you can spend it any way you choose. Be aware that some plans might require you to get a spouse's approval in writing.

• Repayment

You must repay the loan within five years on an amortizing basis, unless you're using it to purchase a home to serve as your primary residence, a condition that allows for a longer payback period. Ask whether your payments on the loan will be reinvested immediately or if they'll be held in a fund and reinvested once the loan is repaid in full. You'll lose potential earnings if the latter is true, which could sway your decision about whether to borrow from the account.

Also, if you leave your job, you'll probably have to repay the entire loan balance within three months. If you can't repay, the unpaid loan balance is considered an early withdrawal, and you'll have to pay income taxes plus the 10% penalty if you're under age 59 1/2.

• Interest Rates

Although it's your money, you still have to pay interest on the loan, but the rate might be lower than the interest rates you could get from conventional lenders, especially if you have poor credit.

Unlike home equity loans, the interest on 401(k) loans is not deductible, even if you use the loan for a home improvement project.

• Tapping Investments

Ordinarily, the money will come out of your account balance in equal portions from the plan's various investments, although your plan might let you designate which investments you want to tap.

• No Impact on Credit Rating

Other types of loans impact your credit score, but a loan from your 401(k) has no effect on your credit rating.

• Fees

The Financial Industry Regulatory Authority warns that the fees you pay to arrange the loan might be higher than what you'd pay for a conventional loan.

Explore other options before you resort to taking out a 401(k) loan, and start now to work toward building a more-robust emergency savings fund to avoid future cash shortages. Look for the best savings rates for money market accounts and other liquid savings vehicles.

Disclaimer:This content is not provided or commissioned by American Express. Opinions expressed here are author's alone, not those of American Express, and have not been reviewed, approved or otherwise endorsed by American Express. This site may be compensated through American Express Affiliate Program.

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