401K Loan

So a few days ago, Chokoboii and I were discussing about credit cards and loans and one thing he said that really irked me was: borrowing from CC is always the first choice, it’s the most convenient

I counter with credit cards loans should only be used as a last resort: interest rates are high, fees are high, and convenience is how people end up in the cyclic credit card debt. I asked if he was referring to 0% intro APRs, but his response was: I’m a fan of convenience, so opening an account…waiting for that card to come in..transfer balance..then closing the other one is kinda a waste of time

Somewhere down the road, I found out he owned a condo and then introduced him to HELOC (home equity line of credit), which is more similar to borrowing from a credit card than taking a loan out from a bank. Your HELOC is based off the value of your house and sits there with no fees. You only have to start paying interest once you take money out of it, and once you pay back the whole amount, the interest fees stop. According to Bankrate.com, a $30K HELOC is currently around 4.8% and a $50K is currently around 4.3%, which is a lot cheaper than typical credit card APRs which are at 10%+.

Anyway, what does all this have to do with a 401K loan? After talking to Chokoboii, in an unrelated incident, I was checking out my 401K to see if I should readjust what to invest in. That’s when I noticed there was this Loans or Withdrawals link. Clicking on it, I found out I had the following options:

  • LOAN – PREAPPROVED | $1,000.00 – $15,800.00 | 6.00%
  • PURCHASE OF PRIMARY RESIDENCE LN | $1,000.00 – $15,800.00 | 6.97%

The amount I could borrow looked close to half of my current 401K portfolio. I did a little more research and found this article: 401k Loans and 401k Hardship Withdrawals.

Some interesting things to note:

  • The primary benefit of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default.
  • The government does not set guidelines or restrictions on the uses for 401k loans.
  • In most cases, an employee can borrow up to fifty-percent of their vested account balance up to a maximum of $50,000.
  • Even though you’re borrowing from yourself, you still have to pay interest!
  • unlike interest paid to a bank, you will eventually get this money back in the form of qualified disbursements at or near retirement
  • the interest you pay back into your 401k plan is tax-sheltered.
  • Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days.

Very interesting… Basically, there is no restrictions on what I use the loan for. The loan isn’t subject to taxes nor penalty for early withdrawal (since it’s not really a withdrawal). You have to pay interest on this loan, but you’re not paying the company nor the bank, you’re paying yourself. Since that money would have been accumulating interest or dividends, I assume that’s what your interest is compensating for. The interest you pay back is also tax-free until you withdraw it.

I talked to Derek a bit about this and he said the major drawback is the fact you’re tied to the company until you pay back this loan, because once you quit or get fired, you have to pay back the loan in 60 days, or else the loan would be declared in default and you’ll have to pay taxes + penalty fee for early withdrawal.

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