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A 401(k) loan allows you to borrow money from your retirement savings and pay it back to yourself over time, with interest. While this type of loan can provide quick access to cash at a relatively low cost, it comes with some downsides. Read on to learn how 401(k) loans work, when it may be appropriate to borrow from your 401(k), and when you might want to consider an alternative source of funding.
What Is a 401(k) Loan & How Does It Work?
A 401(k) loan is a provision that allows participants in a 401(k) plan to borrow money from their own retirement savings. Here are some key points to understand about 401(k) loans.
Limits on How Much You Can Borrow
The Internal Revenue Service (IRS) sets limits on the maximum amount that can be borrowed from a 401(k) plan. Typically, you can borrow up to 50% of your account balance or $50,000, whichever is less, within a 12-month period.
Spousal Permission
Some plans require borrowers to get the signed consent of their spouse before a 401(k) loan can be approved.
You Repay the Loan With Interest
Unlike a withdrawal, a 401(k) loan requires repayment. Typically, you repay the loan (plus interest) via regular payroll deductions, over a specified period, usually five years. These payments go into your own 401(k) account.
Should You Borrow from Your 401(k)?
It depends. In some cases, getting a 401(k) can make sense, while in others, it may not. Here’s a closer look.
When to Consider a 401(k) Loan
• In an emergency If you’re facing a genuine financial emergency, such as medical expenses or imminent foreclosure, a 401(k) loan may provide a timely solution. It can help you address immediate needs without relying on more expensive forms of borrowing.
• You have expensive debt If you have high-interest credit card debt, borrowing from your 401(k) at a lower interest rate can potentially save you money and help you pay off your debt more efficiently.
When to Avoid a 401(k) Loan
• You want to preserve your long-term financial health Depending on the plan, you may not be able to contribute to your 401(k) for the duration of your loan. This can take away from your future financial security (you may also miss out on employee matches). In addition, money removed from your 401(k) will not be able to grow and will not benefit from the effects of compound interest.
• You may change jobs in the next several years If you anticipate leaving your current employer in the near future, taking a 401(k) loan can have adverse consequences. Unpaid loan balances may become due upon separation, leading to potential tax implications and penalties.
How Is a 401(k) Loan Different From an Early Withdrawal?
When you withdraw money from your 401(k), these distributions typically count as taxable income. And, if you’re under the age of 59½, you typically also have to pay a 10% penalty on the amount withdrawn.
You may be able to avoid a withdrawal penalty, if you have a heavy and immediate financial need, such as:
• Medical care expenses for you, your spouse, or children
• Costs directly related to the purchase of your principal residence (excluding mortgage payments).
• College tuition and related educational fees for the next 12 months for you, your spouse, or children.
• Payments necessary to prevent eviction from your home or foreclosure
• Funeral expenses
• Certain expenses to repair damage to your principal residence
While the above scenarios can help you avoid a penalty, income taxes will still be due on the withdrawal. Also keep in mind that an early withdrawal involves permanently taking funds out of your retirement account, depleting your nest egg.
With a 401(k) loan, on the other hand, you borrow money from your retirement account and are obligated to repay it over a specified period. The loan, plus interest, is returned to your 401(k) account. During the term of the loan, however, the money you borrow won’t enjoy any growth.
Recommended: Can I Use My 401(k) to Buy a House?
Pros and Cons of Borrowing From Your 401(k)
Given the potential long-term cost of borrowing money from a bank — or taking out a high-interest payday loan or credit card advance — borrowing from your 401(k) can offer some real advantages. Just be sure to weigh the pros against the cons.
Pros
• Efficiency You can often obtain the funds you need more quickly when you borrow from your 401(k) versus other types of loans.
• No credit check There is no credit check or other underwriting process to qualify you as a borrower because you’re withdrawing your own money. Also, the loan is not listed on your credit report, so your credit won’t take a hit if you default.
• Low fees Typically, the cost to borrow money from your 401(k) is limited to a small loan origination fee. There are no early repayment penalties if you pay off the loan early.
• You pay interest to yourself With a 401(k) loan, you repay yourself, so interest is not lost to a lender.
Cons
• Borrowing limits Typically, you are only able to borrow up to 50% of your vested account balance or $50,000 — whichever is less.
• Loss of growth When you borrow from your 401(k), you specify the investment account(s) from which you want to borrow money, and those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for the duration of the loan.
• Default penalties If you don’t or can’t repay the money you borrowed on time, the remaining balance would be treated as a 401(k) disbursement under IRS rules. This means you’ll owe taxes on the balance and, if you’re younger than 59 1 ⁄ 2, you will likely also have to pay a 10% penalty.
• Leaving your job If you leave your current job, you may have to repay your loan in full in a very short time frame. If you’re unable to do that, you will face the default penalties outlined above.
Alternatives to Borrowing From Your 401(k)
Because withdrawing or borrowing from your 401(k) comes with some drawbacks, here’s a look at some other ways to access cash for a large or emergency expense.
Emergency fund Establishing and maintaining an emergency fund (ideally, with at least three to six months’ worth of living expenses) can provide a financial safety net for unexpected expenses. Having a dedicated fund can reduce the need to tap into your retirement savings.
Home equity loans or lines of credit If you own a home, leveraging the equity through a home equity loan or line of credit can provide a cost-effective method of accessing extra cash. Just keep in mind that these loans are secured by your home — should you run into trouble repaying the loan, you could potentially lose your home.
Negotiating with creditors In cases of financial hardship, it can be worth reaching out to your creditors and explaining your situation. They might be willing to reduce your interest rates, offer a payment plan, or find another way to make your debt more manageable.
Personal Loans Personal loans are available from online lenders, local banks and credit unions and can be used for virtually any purpose. These loans are typically unsecured (meaning no collateral is required) and come with fixed interest rates and set terms. Depending on your lender, you may be able to get funding within a day or so.
The Takeaway
Borrowing from your 401(k) can provide short-term financial relief but there are some downsides to consider, such as borrowing limits, loss of growth, and penalties for defaulting. It’s a good idea to carefully weigh the pros and cons before you take out a 401(k) loan. You may also want to consider alternatives, such as using non-retirement savings, taking out a home equity loan or line of credit, or getting a personal loan.
Think twice before turning to high-interest credit cards. Consider a SoFi personal loan instead. SoFi offers competitive fixed rates and same-day funding. Checking your rate takes just a minute.
SoFi’s Personal Loan was named NerdWallet’s 2023 winner for Best Online Personal Loan overall.
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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.
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Source: sofi.com
