Your 401(k) or individual retirement account enables you, and possibly your employer, to make pretax contributions that can compound throughout your working years. Generally, the Internal Revenue Service doesn't allow penalty-free withdrawals from retirement accounts until you're age 59 1/2, although some special circumstances apply, such as hardship withdrawals and fund rollovers. However, in some cases, you may be able to borrow against your 401(k) or IRA.
Borrowing Against Your 401(k)
To borrow against the funds in your 401(k), you will need to determine whether your employer and your 401(k) administrator allow it. Not all companies allow such loans. If you are able to borrow against your funds, your human resources department can give you the specific instructions and necessary paperwork. You will usually only be able to borrow funds that are vested in your account. This means the money has been in your account for a length of time determined by your employer and is therefore available to you. Vesting only applies to your employer’s contributions; your own contributions are vested immediately.
401(k) Loan Repayment
Borrowing against your 401(k) is usually simpler than taking out a personal loan. There is no credit check or application period because the funds in the account are legally yours. However, when you take out a 401(k) loan, you will need to repay the money in five years, along with interest. Repayment and interest is typically deducted straight from your paycheck. You can usually borrow up to 50 percent of your vested funds.
Pros and Cons
A 401(k) loan can be easy to obtain, and the interest you pay will go back to your account, so you are essentially paying yourself interest. By borrowing against your 401(k), you also won't face the taxes and penalties that come with a permanent withdrawal. However, when you borrow money from your retirement account, you no longer earn the compounded earnings that make these accounts a good investment tool for your retirement. Most employers and account administrators also won't let you contribute to the account until the loan is repaid.
Borrowing Against Your IRA
An IRA is basically a retirement account that isn't sponsored by your employer. A traditional IRA allows you to make pretax contributions, and earnings are tax-free until you begin withdrawing the money after 59 1/2. While you aren't allowed to borrow against an IRA, you may be able to receive a short-term loan. You are allowed to withdraw funds from your IRA without taxes or penalties if you return the money to the account or deposit it into another IRA within 60 days.
This is called an IRA rollover, and it can be a good option if you only need the cash for a short period. To arrange a rollover, call your account administrator and submit the necessary paperwork. If you fail to deposit the funds back into your IRA or into another IRA within that time frame, you will be required to pay taxes on the money and a 10 percent early withdrawal penalty.
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