A 401(k) is an integral part of many people’s retirement strategies. But did you know you may be able to take out a loan against it?
There are plenty of pros and cons associated with this plan. However, it can be beneficial to avoid the loan application process, credit check, and heavy interest associated with many lenders.
It’s a big decision to make, so we’ll walk you through the entire process to help you understand exactly what to expect with a 401(k) loan.
Ready to get started?
What is a 401(k) loan?
If your employer offers a 401(k) to employees as part of your retirement savings strategy, chances are you could be eligible to take out a loan from your contributions.
After all, among both mid and large-sized companies, a full 94% allow 401(k) loans on the money you have contributed. In addition, 73% of these employers also allow employees to borrow money against the employer’s contributions.
So rather than having to either wait to access your retirement savings or pay a 10% penalty tax as you would with a traditional IRA, you can borrow your own money instead.
When can you borrow money from your 401(k)?
There are a few restrictions surrounding a 401(k) loan. While we mentioned that many larger companies typically allow you to borrow for your account, not all do. You can find out about your workplace policy by referencing your employee handbook or contacting the human resources department.
You also must still be working at the company where you had your 401(k) to take out a loan. So if you left willingly or were fired, unfortunately, you aren’t able to take advantage of this opportunity.
There are also some limits on how much you can borrow from your account. IRS regulations state that you can only borrow the smaller of the following two options:
- $50,000 or
- Half the amount of your vested account balance
Your interest rate is also determined by when you borrow. That’s because it’s typically set at the prime rate plus an extra 1% to 2%. So if the prime rate is at 4.25% and your employer’s 401(k) plan adds 2%, you’re looking at a 6.25% interest rate. The interest does, however, go directly back into your retirement account.
What are the benefits of borrowing from your 401(k)?
Like any financial product, the 401(k) loan comes with both pros and cons. Some experts scream that you should never touch your retirement savings, while others have noted countless success stories.
It’s essential to weigh the positives and negatives concerning your situation thoroughly. Then, you can make a fully informed decision on whether or not a 401(k) loan is right for you specifically.
Being your own lender comes with a few perks.
First, you don’t have to fill out an application. There’s no underwriting process since the funds are already in your name. You also don’t have to worry about any type of minimum credit score.
So if you need an infusion of cash for some reason but have gone through a rough financial patch, you can sidestep a bad credit loan and the accompanying bad credit.
In addition to having no credit check or application, you also have easy repayment terms.
Your monthly payment is deducted straight from your paycheck, and the maximum term is five years. That gives you flexibility in how large or small you prefer your monthly payment.
Use of Loan Funds
Another benefit is that there aren’t any restrictions on what you can use the loan funds for. You could use the money for your child’s college tuition, for a business opportunity, or even for debt consolidation — it doesn’t matter. There’s no underwriter checking to see what you spent the money on.
With interest rates historically low, you may also be attracted to the 401(k) loan’s relatively low APR. After all, if you compare it to a high-interest credit card or even a personal loan from a bank or online lender, you could be saving a lot of money on interest.
Lower Interest Rate
When borrowing money from your 401(k), you will usually have a lower interest rate than you would on credit cards or personal loans.
What are the drawbacks of borrowing from your 401(k)?
While taking out money from your 401(k) may seem like a great idea, it’s important to truly weigh the impact of this decision from both a short-term and long-term perspective.
It may sound nice to pay yourself interest, but you’re essentially getting taxed twice in the process.
Typically, any contribution you make to your 401(k) does not count towards your income tax because you’ll be taxed when you start taking distributions during retirement. Your interest payments, however, are taxed. They’ll then go into your 401(k), and when you make a withdrawal, you’ll be taxed again.
It’s essentially a taxation double whammy.
You also may not be allowed to continue making retirement contributions during the repayment period — it depends on your employer’s plan. Your retirement nest egg could take a huge hit during the process.
First, you’d lose any gains made on the funds you took out. Then, you’d be taking a hiatus for at least a few years. That can really add up when you think about compounding gains.
Leaving Your Job Could Accelerate Loan Repayment
And what happens if you leave your job when you’re in the middle of repaying your 401(k) loan?
You’ll have to pay back the entire remaining loan balance within 60 days. Depending on how much you took out and how long you’ve been making payments, that can be a huge financial burden.
If you can’t repay the loan within the designated period, you may have to declare that remaining loan amount as income and pay income taxes on it. You might also be forced to pay the 10% penalty for early withdrawal.
Avoiding those expensive consequences was probably part of the reason you considered a 401(k) loan in the first place. But if you want a career move or suddenly get laid off, you could end up losing those benefits.
How do 401(k) loan repayments work?
If you decide to take out a 401(k) loan, make sure you understand how the loan repayment process works. Your loan payments are taken directly out of your paycheck, but there is a certain degree of risk involved. If for some reason, you can’t (or simply don’t) make a payment for 90 days, you’ll incur significant penalties.
It’s almost considered to be a short-term default because you’ll pay taxes on it and the 10% early withdrawal penalty on the amount owed.
When you take out a 401(k) loan, you don’t have to pay any type of application fee or origination fee, so it seems like a low-cost option. But again, you have to take into account the money you’re losing by not having as much invested in your account.
A great way to analyze the numbers is to use a retirement calculator. You can get a general idea of how much earnings you’ll be sacrificing to get your loan funds right away, then determine if it’s worth it or not.
Should you use your 401(k) for a loan?
This is a personal decision, and there are many factors to consider regarding whether or not a 401(k) loan is a good idea. First, think about how far away you are from retirement. If you’re expecting to start making withdrawals in the near future, you may want to reconsider dipping into that money ahead of schedule.
If you’re further away from retirement, you have more time to make up for any financial losses you’d incur while the loan is out. Just make a plan to ensure you’re able to catch up over time.
Of course, your intended use for your 401(k) loan funds also affects whether or not it’s a good choice. Short-term uses are a little less worrisome. For example, if you’re using it for a down payment on a house and can quickly repay the loan, it can be a good way to avoid those penalties.
But if you’re using the 401(k) loan as a band-aid during an ongoing financial downturn, you may want to think again. Is it really solving the problem or just providing temporary relief?
Also, think twice about using your 401(k) loan to pay off debts. If you’re still in financial trouble, you can lose your existing assets.
But retirement savings are typically protected from any kind of insolvency, but not if they’ve been taken out as a loan. If there’s a chance you might lose the money permanently, try to find another solution.
What other options do you have?
A 401(k) loan isn’t the only alternative to a traditional personal loan. Here are a few other options to consider.
Ideally, you have accessible cash set aside to use in the case of a financial emergency. Most experts recommend at least six months of income to tide yourself over. Just make sure any use of this money truly is for an emergency.
Home Equity Loan
Home equity loans are for people who have a fair amount of equity in their homes. It’s essentially a second mortgage, but the repayment term lasts a much shorter period. The pro is that the interest you pay on the loan is tax-deductible.
401(k) Taxable Withdrawal
Here’s another way to utilize your 401(k) funds. Instead of taking a loan, you may be able to take out a hardship withdrawal. If you’re using the money for medical needs, you may be able to avoid the 10% penalty, although you’d still have to pay tax on whatever you take out.
IRA 72(t) Withdrawal
If you have an IRA, this allows you to avoid the 10% penalty if you’re under 59 ½ years old. The catch, however, is that you must take equal distributions out each year for either five years or until you reach the age of 59 ½ — whichever is longer.
The bottom line is that financial planning takes a lot of strategizing. You’ve got to weigh your needs today without discounting your needs 20 or even 30 years from now (and likely even longer!).
A 401(k) loan can be a useful tool, but it’s definitely one with which you should decide on with ample reflection. Get creative about all of your financial options before making the commitment.