What You Should Know About 401(k) Loans
A 401(k) is a financial instrument used to save for retirement. You and your employer can both contribute, and the account earns interest. There are some financial actions you can take with your 401(k) if you need to, depending on whether the program managers and your employer allow it.
If you are in a pinch and need money quickly, you can take a loan from your 401(k), instead of paying double-digit interest to a credit card company. You'd pay interest to yourself, effectively contributing more money to your retirement plan.
There are a few considerations you should take before taking out a loan from your retirement account. There is a maximum amount you can pull out of your account, and a repayment period that must be met.
A 401k Loan:
- Doesn't involve a credit check
- Has an easy loan application process
- Isn't reported to credit bureaus
- Has interest repaid to your own account
- Has a maximum amount the lessor of 50% of the balance or $50,000
- You have a time limit to repay the money, and the repayments don't count as contributions.
The Positive Aspects of 401(k) Borrowing
While the whole point of a 401(k) is to put away money that you won't touch until retirement, taking a loan from your plan may be the best option you have under certain circumstances. A high-interest title loan, pawnshop, credit card cash advance, or even a more reasonable personal loan can still cost more than double the interest you'd pay on a 401(k) loan. (Figure your monthly payments based on interest rates for a personal loan with our calculator below.)
If you know you'll have the means to repay the loan within a short term, there are a few redeeming factors that make these loans sensible under certain scenarios. The designers of the 401(k) plan have the option to include the ability for hardship distributions, which allow for withdrawals from the account for defined hardships, such as emergency medical expenses or a mortgage payment.
The Downside of 401(k) Loans
There are a few major catches to a retirement account loan. If you should ever need to declare bankruptcy, ordinarily, your retirement plan assets, such as a 401(k), 403(b), traditional IRA, Roth IRA, simplified employee pension (SEP) IRA, and simple IRA are protected, like safe havens, or lock boxes that creditors have a very hard time touching.
If you raid your 401(k) to try and save your home, that money is available to creditors once it is taken out of the account in the form of an outright withdrawal or loan.
If you lose your job or change employers, your entire 401(k) loan balance is due within 60 days. If you can't repay it, the IRS and your state treat the funds as a withdrawal. You will owe all federal and state income taxes on it, plus an additional 10% penalty tax if you are under the age of 59.5. You'll be lucky to be left with 70 cents on the dollar—which means right when you are out of work or starting a new job, you are also getting a hefty tax bill.
Not All 401(k) Plans Let You Take a Loan
While the law allows companies to offer 401(k) loans in their plans, they are not required to do so. In fact, some employers oppose the entire idea of 401(k) loans because management or owners believe that retirement assets in these accounts should be as sacrosanct as pension assets—held beyond reach and out of the way of temptation. Additionally, some employer plans only permit 401(k) loans for specific purposes.
During the Great Recession of 2008–2009, a number of people who were living with too much debt found themselves unable to make credit card payments or pay their mortgage.
Instead of declaring bankruptcy or going into foreclosure, many attempted to withdraw from their 401(k) assets which triggered regular income taxes plus a 10% penalty tax for those under the age of 59.5 years old, or they risked a 401(k) loan.
Many decided to go with the loan until they found out that their company plan didn't offer 401(k) loans for this very situation—to prevent people from losing their retirement when markets fluctuate and cause other losses.
The Maximum You Can Borrow
Even if you have millions of dollars in your retirement account, the biggest 401(k) loan you can take is equal to the lesser of 50% of your account balance or $50,000. There are no exceptions. It makes more sense to use your savings than to withdraw from your retirement plan, only to lose the opportunity for it to make more money for you, and for you to pay interest on it—which adds to the expenses you might have withdrawn it for.
The Interest Rate on Your Loan
When repaying money borrowed from your retirement plan, you must pay interest, which is typically the prime rate plus 1%-2%. True, the interest is paid to yourself, meaning it is more of a transfer from one pocket to another than it is a real expense, but you still have to come up with the cash. Unfortunately, you don't control the interest rate—the plan sponsor does.
The Repayment Period for 401(k) Loans
When you borrow from your 401(k) account, you are required to repay the money, with interest, over 60 months. That five-year period can be extended for those who use the borrowed money to purchase a primary residence, though in most cases, a 401(k) loan isn't going to be nearly as attractive as a traditional mortgage loan from a local bank.
Consider a 401(k) Loan Very Carefully
While the 401(k) plan can be a great way to save for retirement by building wealth through years of tax-advantaged compounding, removing money from the account early through a loan can really cost you, even if you intend to repay the funds. Review all of the pros and cons as they pertain to your specific situation and speak with your financial advisor before making your final decision.
Due to the Covid-19 Pandemic congress enacted legislation under the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) in March of 2020, which provides additional flexibility related to 401(k) loans and hardship withdrawals. Visit the IRS' CARES Q&A website for further information