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When you take out a loan from your 401(k) plan, you’ll have terms like any other type of loan: There’s a repayment plan based on how much you borrow and the interest rate you lock in. According to the IRS Under the rules, you have five years to repay the loan, unless the money is used to purchase your primary home. In that case you have more time to repay.
The ability to take out a loan makes a 401(k) plan one of the best retirement plans, but a loan has some significant drawbacks. As you pay yourself back, you’re still removing money from your retirement account that grows tax-free. And the less money there is in your plan, the less money will grow over time. Even if you pay the money back, it has less time to fully grow.
Additionally, if you have a traditional 401(k) plan, you pay back the pre-tax money in the account with your after-tax earnings, so it takes even more time (in terms of work hours) to pay the money back. loan.
Risks of Taking Out a 401(k) Loan
Before you decide to borrow money from your 401(k), keep in mind that it has its drawbacks.
- You may not get one. The ability to get a 401(k) loan depends on your employer and the plan they have in place. A 2023 study from the Employee Benefit Research Institute and the Investment Company Institute found that 84 percent of plans had outstanding loans, based on 2020 data, so you may have to look elsewhere for money.
- You have limits. You may not have access to as much cash as you need. The maximum loan amount is $50,000 or 50 percent of your vested account balance, whichever is less.
- Old 401(k)s don’t count. If you plan to tap into a 401(k) from a company you no longer work for, you’re out of luck. Unless you’ve put that money into your current 401(k) plan, you can’t take out a loan against it.
- You could pay taxes and fines on it. If you don’t pay back your loan on time, the loan could become a distribution, meaning you may have to pay taxes and bonus penalties on it.
- If you leave your job, you need to pay it back faster. If you change jobs, quit your job, or are fired by your current employer, you must pay off your outstanding 401(k) balance sooner than five years. Under the new tax law, 401(k) borrowers have until the due date of their federal income tax return to repay in such circumstances.
For example, if you had a 401(k) loan balance and left your employer in January 2024, you have until April 15, 2025 to repay the loan to avoid default and any tax penalties for early withdrawal, according to The Retirement. Planning company. The old rule required repayment within 60 days.
Benefits of Borrowing from a 401(k)
Borrowing from your 401(k) isn’t ideal, but it does have some advantages, especially compared to an early withdrawal.
- Avoid taxes or fines. With a loan, you can avoid paying the taxes and penalties associated with an early withdrawal. In addition, the interest you pay on the loan is returned to your retirement account, albeit after taxes.
- Avoid credit checks. A 401(k) loan also does not require a credit check and will not show up as debt on your credit report. If you are forced to default on the loan, you don’t have to worry about it hurting your credit score because the default won’t be reported to credit bureaus.
When a 401(k) loan makes sense
Borrowing from your 401(k) should be a rare occurrence, but it may make sense if you need a significant amount of cash in the short term. It should not be used for small quantities or for items that are not absolutely necessary.
A 401(k) loan is often a better financial choice than other short-term financing options, such as a payday loan or even a personal loan. These other loan options typically have high interest rates, making them less attractive. Additionally, a 401(k) loan is relatively easy to arrange compared to applying for new loans from other financial institutions.
Can you pay off a 401(k) loan early?
Yes, loans from a 401(k) plan can be repaid early without a prepayment penalty. Many plans offer the option to repay loans through regular payroll deductions, which can be increased to pay off the loan sooner than the five-year requirement. Keep in mind that these payments are made with after-tax dollars, unlike contributions that can be made before taxes.
Does your employer know if you are taking out a 401(k) loan?
Yes, it is likely that your employer is aware of any loan from its own sponsored plan. You may have to apply for the loan through the human resources department (HR) and pay it back through payroll deductions, which they are also aware of. Loans are also not guaranteed to be approved, or your plan may not offer them at all.
If you are concerned about a manager or supervisor finding out about the loan application, consider asking HR to keep your request confidential.
Early withdrawals are less attractive than loans
An alternative to a 401(k) loan is a hardship distribution as part of an early withdrawal, but that comes with a variety of taxes and penalties. If you withdraw the money before retirement age (59.5), you will generally be charged with income tax on any gains and may face a 10 percent bonus penalty, depending on the nature of the hardship.
The IRS defines a hardship distribution as “an immediate and severe financial need of the employee,” adding that the “amount must be necessary to meet the financial need.” With this form of early withdrawal, you do not have to repay the amount and there are no penalties involved.
A hardship distribution due to an early withdrawal covers a number of different circumstances, including:
- Certain medical costs
- Some costs for buying a main home
- Tuition, fees and training costs
- Costs to prevent eviction or foreclosure
- Funeral or funeral expenses
- Emergency home repairs for uninsured losses
Hardships can be relative, and yours may not qualify for early retirement.
With this type of withdrawal, you do not have to pay it back. But it’s a good idea to avoid an early withdrawal if possible, because of the serious negative consequences for your retirement funds. Here are a few ways to avoid those hefty levies and keep your retirement on track.
Other Alternatives to a 401(k) Loan
Borrowing from yourself may be a simple option, but it is probably not your only option. Here are a few other places to find money.
Use your savings. Your emergency money or other savings may be critical right now – and why you have emergency savings in the first place. Always try to find the best interest rate on a high-yield savings account so that you earn the highest amount on your money.
Take out a personal loan. Personal loan terms can make it easier for you to repay without having to put your retirement funds at risk. Depending on your lender, you could receive your money in about a day, while 401(k) loans may not be as immediate.
Try a HELOC. A home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow against. You can take out what you need, when you need it, up to the limit you’re approved for. As revolving credit, it is comparable to a credit card: the money is there when you need it.
Get a mortgage loan. You can usually get a lower interest rate with this type of loan, but keep in mind that your home will be used as collateral. This is an installment loan and not revolving credit like a HELOC, so it’s good to know exactly how much you need and what it will be used for. Although it is easier to get this loan, you need to make sure that you can repay this loan or you risk defaulting on your home.
In short
If withdrawing money from your retirement is your only option, a 401(k) loan may be right for you. However, try to find other funds first before using this option. Depending on what you need and when you need it, you may have other choices that are better for your situation. Not having emergency or retirement savings is Americans’ biggest financial regret.
