One of the greatest benefits of a 401(k) is also a potential drawback: the 401(k) loan. Not all 401(k) plans let employees borrow a portion of their own savings. This decision is left up to the employer and plan administrator. But many retirement plan sponsors do offer this option.
If your plan offers a loan that you have considered taking, learn more about what’s good and bad about 401(k) loans.
401(k) Loan Advantages
The biggest advantage of a 401(k) loan is that you are both the borrower and the lender, so you pay yourself back with interest. If you have to take a loan, it’s better than having to pay back anyone else. 401(k) loans are typically offered at a very competitive rate of interest. Interest rates are usually tied to the prime rate and can often be significantly lower than other forms of debt such as credit cards or personal loans. The interest you pay yourself is tax-deferred and you won’t pay taxes on it until the 401(k) is distributed after retirement.
You skip many of the loan application and processing fees that can add to your loan debt (Note: Fees may vary so it is important to double-check to see if there are any application fees). You do have to apply, but you will not likely be turned down and you can access your funds rather quickly. These loans have few if any restrictions and no credit check is required. (And a default on this type of loan does not have the same credit impact that it would on a traditional loan.)
401(k) Limits and Restrictions
Typically, individuals are allowed to borrow 50% of their 401(k) account balance up to a maximum of $50,000. They may also have a minimum threshold of around $1,000. Terms for 401(k) loans typically five years or less; the only exception would be if you are using the money to buy a home, you may be given a longer payback period. As the owner of the 401(k) account, you can decide which assets to liquidate to borrow from, so you may be able to borrow the money without having to touch your better-performing investments. Your plan administrator can give you a sense of limits and restrictions specific to your account.
The CARES Act temporarily allowed plans to increase the maximum 401(k) loan amount to $100,000 for participants impacted by COVID-19. This applied to loans made from March 27, 2020 to Sept. 22, 2020.
401(k) Loan Disadvantages
There are two major disadvantages to a 401(k) loan. The first is that you are utilizing the money that would otherwise be working for you. It’s an opportunity cost because you are missing out on potential growth. (To be fair, you could also miss out on a bad market, which may be a good thing.) Sure, you are earning interest as a lender, but it’s not a high rate of interest.
The second disadvantage is the potential for default. Historically, if you lose your job or leave your job, many plans would require that you pay back the loan within 60 days. After that, it will be considered a distribution on your 401(k). You will likely owe taxes on the money, plus (if you are younger than 59 ½) a 10% penalty fee. Imagine a scenario in which you are laid off and suddenly made to choose between a hefty loan bill or a hefty tax bill. This could easily happen if you take a 401(k) loan.
There are some exemptions to 401k early withdrawal penalties. 401(k) loans became a little less dangerous with the new tax law. When leaving an employer you now have until the due date of your tax return (including extensions) to put the money back into your 401(k), an IRA, or a retirement plan at a new employer.
The CARES Act allowed plan providers to suspend repayment of 401(k) loans for up to one year for loans due from March 27, 2020 to Dec. 31, 2020.
So Should You Take a 401(k) Loan?
The bottom line is you need a 401(k) to foster a secure retirement. Anything that puts that at risk should be considered carefully. If your only other choice is to pull the money out of your 401(k) entirely, then a loan is the better option. However, if you have any other options, just leave the 401(k) alone.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.