Borrowing from your 401(k) plan can be helpful in accessing funds when you need it – here’s what to know

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If you need funds quickly, a 401(k) loan offers several advantages over other loans or 401(k) plan withdrawals – but there are many rules to follow. Jesse Casson/Getty
  • A 401(k) loan allows you to borrow money from your retirement account and repay it within five years, with interest.
  • A 401(k) loan isn’t the same as a withdrawal, but there are still specific rules to follow.
  • Any funds borrowed through a 401(k) loan won’t grow, so you should borrow funds only as a last resort.
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Your retirement accounts are meant for saving and investing money instead of borrowing it. However, if you find yourself in a situation where you need to borrow money and have few options, a 401(k) loan may be helpful for your situation.

A 401(k) is an employer-sponsored retirement plan that allows you to make pre-tax contributions. There are penalties for withdrawing money from your account before 59 ½, but you can borrow some of your 401(k) money if you’re able to follow a few specific rules.

What is a 401(k) loan?

A 401(k) loan is exactly what it sounds like – borrowing from your own 401(k) account and paying yourself back over time. However, a 401(k) loan isn’t a true loan since there’s no lender or credit score evaluation. Your 401(k) company may have its own limits on loan amounts, but the IRS limits how much you can borrow to whichever is less: $US50,000 ($AU68,489) or 50% of you vested 401(k) balance.

You do, however, have to pay origination fees and interest – you’ll just pay this back to yourself. To borrow money from your 401(k), you’d need to ask your employer about their 401(k) loan options and fill out the necessary paperwork.

401(k) loan rules

There are a lot of important rules to keep in mind if you’re going to use a 401(k) loan.

  • You can borrow only a maximum of $US50,000 ($AU68,489) or 50% of your vested 401(k) balance within a 12-month period.
  • A portion of the amount you borrowed, plus interest, is withheld from each paycheck right after the loan funds are dispersed to you.
  • Borrowers typically have up to five years to repay the loan. (The only exception to this repayment term is if you’re using the loan to purchase a primary residence.)
  • If you lose your job during the repayment process, the remaining loan amount may be due immediately or with your next tax payment.
  • If you’re unable to repay your 401(k) loan by the end of the tax year, the remaining balance will be considered a distribution and you’ll need to pay taxes as well as a 10% early withdrawal fee penalty on the amount.
  • Depending on your retirement plan, you may need your spouse’s consent to borrow more than $US5,000 ($AU6,849).

“The interest rate on 401(k) loans tends to be relatively low, perhaps one or two points above the prime rate, which is less than [what] many consumers would pay for a personal loan,” says Arvind Ven, CEO of Capital V Group located in California. “Also, unlike a traditional loan, the interest doesn’t go to the bank or another commercial lender, it goes to you.”

Ven also warns that if you’re unable to repay your 401(k) loan, the brokerage company managing your 401(k) will report it to the IRS on Form 1099-R.

“By then, it’s treated as a distribution which includes more fees, so it’s important to keep up with payments and stay on track.”

Pros and cons of a 401(k) loan

There are some people who might say that getting a 401(k) loan is a good idea while others would disagree. This is why it’s important to compare the pros and cons so you can make the best decision for your situation.

Pros

You can get quick access to funds when you need it. The biggest benefit of getting a 401(k) loan is that you’ll quickly gain access to cash to cover costs like medical expenses or home repairs. There’s no credit check, and repayment rules are also flexible since payments are taken out of your paychecks. You won’t have to worry about scraping up money for loan payments when you’re in between paychecks.

Any interest paid goes back to you. “With a 401(k) loan you are paying interest to yourself rather than a third-party bank or credit card company”, says Bethany Riesenberg, a CPA at Spotlight Asset Group. “In many cases, the interest rate is lower than credit card rates, so it may make sense to take out a 401(k) loan to pay off high-interest debt you have.”

Cons

Withdrawn funds won’t benefit from market growth. The biggest drawback is that the money you take out of your 401(k) account won’t grow. Even if you pay the money back within five years including any interest, this still may not make up for the money you lost if market growth occurred at a higher rate on average during those five years.

You’ll have to pay fees. Fees are another issue since borrowing from your 401(k) is far from free. Yes, you’ll be paying interest back to yourself, but that’s still extra money you’ll need to hand over. Plus, you may pay an origination fee along with a maintenance fee to take out a 401(k) loan based on your plan.

Payments made toward the loan are taxed. Another thing to consider is that your loan repayments are made with after-tax dollars (even if you use the loan to buy a house), and you’ll be taxed again when you withdraw the money later during retirement.

You might not be able to contribute to your 401(k). “Some plans do not allow you to continue to contribute to your 401(k) if you have a loan outstanding,” says Riesenberg. “That means, if you take five years to pay off the loan, it will be five years before you can add funds to your 401(k), and you will have missed savings opportunities as well as missing out on the tax benefits of making 401(k) contributions.”

Additionally, if your employer makes matching contributions, you will also miss out on those during the years where you aren’t contributing to your 401(k).

You might need to pay off immediately if you leave your employer. Finally, an important drawback to consider is if you leave your job before the 401(k) loan is repaid. In this case, your plan sponsor may require you to repay the full 401(k) loan. Also, the IRS requires borrowers to repay their 401(k) loan balance in full upon the tax return filing date for that tax year. If you’re unable to meet those requirements, the amount may be withdrawn from your vested 401(k) balance and treated like a distribution (subject to a 10% withdrawal penalty).

Pros Cons
  • Fast access to money (no application or credit check required)
  • Can borrow up to $US50,000 ($AU68,489) or 50% of your vested 401(k) balance
  • Interest rate is lower than credit cards and most personal loans
  • Interest is paid back to your account
  • 5-year loan term may be extended if you borrow the funds to buy a primary residence
  • Lose out on account market growth
  • May not be able to make retirement contributions during repayment
  • Miss out on employer match if you can’t make contributions (until the loan is repaid)
  • Loan payments are made with after-tax dollars
  • Loan turns into a distribution and is subject to taxes and penalties if you can’t pay it back

401(k) loan vs. 401(k) withdrawal

You should utilize a 401(k) loan if you intend to pay the money back to your retirement account. However, if you’re just looking to take money out for an expense, this would be considered a withdrawal.

Withdrawing money early from your 401(k) is often not recommended since you’ll be subject to fees and taxes if you’re not at least age 59 ½.

Let’s look at an example of how a 401(k) loan would work: Let’s say you needed $US25,000 ($AU34,244) immediately to pay off high-interest debt and you have a vested 401(k) balance of $US60,000 ($AU82,186). If you took out a 401(k) loan, you could receive a maximum of $US30,000 ($AU41,093) (the lesser of $US50,000 ($AU68,489) or 50% of your vested balance).

But in this case, you could borrow $US25,000 ($AU34,244) from your plan (minus any incremental fees), which would leave you with a 401(k) balance of $US35,000 ($AU47,942) in your plan, and no taxes or penalties would be due related to your loan. Assuming the loan has a five-year term, a 5% interest rate, and you pay back your loan through bi-weekly payroll deductions, you’ll make a payment every pay period of $US235.89 ($AU323) ($US471.78 ($AU646) each month). That means you’d end up repaying $US28,306.85 ($AU38,774) in total ($US25,000 ($AU34,244) + $US3,306.85 ($AU4,530) [in interest] = $US28,306.85 ($AU38,774)).

After five years, your loan will be fully paid off and your 401(k) account will now include all the loan and interest payments you made ($US35,000 ($AU47,942) + $US28,306.85 ($AU38,774) = $US63,306.85 ($AU86,716)).

Now let’s take an example of taking an early 401(k) withdrawal instead: If you take a withdrawal from your 401(k), you’ll need to take out more money due to penalties and taxes to net $US25,000 ($AU34,244). In this instance, you’d have to take out $US39,683 ($AU54,357), which results in taxes and penalties of $US14,683 ($AU20,112) (assuming a 20% federal tax rate, 7% state tax rate, and 10% early withdrawal penalty). This means your 401(k) balance (originally at $US60,000 ($AU82,186)) is down to $US20,317 ($AU27,830) – almost $US15,000 ($AU20,547) less than what it would be if you took out a 401(k) loan.

“Some plans have hardship withdrawals, which provide funds in very specific emergency cases, but you must have an immediate and heavy financial need,” says Riesenberg.

Riesenberg also adds that if you are allowed a hardship withdrawal from your 401(k) account, you’re not required to pay the 10% early withdrawal penalty.

The financial takeaway

401(k) loans could be an ideal way to pay off high-interest debt or cover a dire emergency if you’ve exhausted all other options. On the flip side, borrowing from your retirement account comes with a lot of risk if you can’t afford to repay the loan or if you leave your job before the repayment term is up.

In most cases, it’s safer to not touch your retirement savings and resort to other options of borrowing cash, whether it’s a low-interest personal loan or 0% APR credit card. Before you decide on a 401(k) loan, you should also consult with a financial planner who can help you explore all your options and also predict how the loan would impact your future retirement.

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