The Pros and Cons of Borrowing From Your 401(k)

A lesbian couple considers taking a loan from a 401(k) account
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Taking out a loan from your 401(k) plan can be the financial lifeline you need when you incur a large and unexpected debt. But tapping into your retirement account is a move that shouldn't be taken lightly, and you should carefully consider the pros and cons.

Pros
  • There's no loan application.

  • No minimum credit score is required.

  • The money isn't counted as a debt on your credit report.

  • It may be cheaper than borrowing from a bank.

  • You won't pay income tax or a penalty tax on the withdrawn amount.

  • You repay the loan with automatic paycheck deductions.

Cons
  • Not all employers permit loans from their plan.

  • There's a limit on how much you can borrow.

  • You may lose investment gains from the money you withdrew.

  • You might feel tethered to your employer for longer than you want.

  • Your withdrawn money will no longer be protected in the event you go bankrupt.

The Pros of Borrowing From Your 401(k)

There are several reasons why tapping your 401(k) for needed cash makes sense.

No Loan Application

Because you're taking your own money out of your own account, you don't have to apply for a loan to borrow against your 401(k) and you may not have to give an explanation for why you need the money. You still have to provide some information to your plan's administrator, but it's not as complex a process as applying for a loan from a bank or credit union.

Credit Scores and Credit Reports

Similarly, because you're accessing your own saved money, your credit score—a number that's used to quantify your creditworthiness to potential lenders—doesn't affect your ability to withdraw the money. In addition, the borrowing of funds doesn't result in a hard inquiry—which occurs when a lender wants to take a look at your credit report—and so you won't experience a resulting dip in your credit score.

Your plan administrator doesn't report your repayments to the three major credit reporting agencies—Equifax, Experian, and TransUnion—so if for some reason you don't repay all of the money, your credit score and reports won't be affected.

Lower Interest Rate

You should be able to borrow at a lower rate than you would get from a bank. The typical interest rate you will have to pay is the prime rate plus 1% or 2%. As of Sept. 25, 2020, the prime rate—the rate banks charge their least risky corporate clients—was 3.25%.

No Taxes Owed

The Internal Revenue Service does not require you to pay income tax or a 10% early withdrawal penalty on the money you take out so long as you repay it back in time, generally within five years but perhaps as long as 15 years if you took out the money to purchase a home.

There is typically no penalty for repaying the money to your 401(k) early, before the end of the loan term.

Automatic Deductions

You repay the money using deductions taken out of your paycheck. As long as you remain at the same employer during the repayment period, the process should be easy.

The Cons of Borrowing From Your 401(k)

There are also valid reasons why it might not be a good idea to pull money from your retirement account.

Loans May Not Be Permitted

Some employers don't allow workers to borrow from their retirement account, so a 401(k) loan may not even be an option for you. Contact your plan administrator or look at its website to see whether loans are permitted.

You may not borrow from a plan that was set up by a former employer. However, you may roll over that plan's balance into your current employer's plan and then borrow that money.

Borrowing Limits

The maximum you can borrow from your 401(k) is $50,000 or 50% of the balance, whichever is smaller. If your plan allows you to take out multiple loans, the total amount borrowed may not exceed that amount or percentage.

Loss of Potential Gains

Because the money you withdrew is no longer in a mutual fund or other type of investment, you may miss out on gains your nest egg otherwise would have benefited from. This missed chance to make more money from that money can be described as an opportunity cost.

Employer Attachment

If you leave your employer before repaying your loan, any outstanding balance may be treated as a taxable distribution to you unless you repay it entirely within a specific amount of time. Trying to avoid that scenario may leave you in a job longer than you would care to be there.

Giving Up Bankruptcy Protection

Assets of your 401(k) are protected from creditors during bankruptcy proceedings. If you borrow funds from the plan to help pay debts but nonetheless remain in financial trouble and end up filing for bankruptcy, any remaining withdrawn funds may be seized by creditors.

Who Should Borrow From a 401(k)

If you have a large amount of high-interest debt, such as from credit cards, tapping your 401(k) to pay off that debt and then pay yourself back at a lower interest rate makes sense.

You may also find yourself in an immediate financial emergency, such as needing money to pay the $6,000 deductible on your high-deductible health insurance plan before you can get medically necessary treatment. In that scenario or a similar one, you may understandably feel like you have no choice but to take the 401(k) loan.

Who Should Not Borrow From a 401(k) Plan

If you are planning to change jobs in the near future, you should reconsider tapping into your 401(k). And if your reason for taking out a 401(k) loan isn't a true emergency—it's a want, not a need—you would be better off leaving the money where it is.

An Example of a 401(k) Loan

Let's assume you have $5,000 of credit card debt and $50,000 in a 401(k) plan. You borrow $5,000 and agree to pay off the debt within five years at an annual percentage rate of 4.25%. At the end of the five years, after having made payments of $92.65 a month, you will have replenished your account and paid yourself $558.83 in interest.

If you took the same amount of time to pay off the $5,000 of credit card debt, which had an annual percentage rate of 14.25%, using money left over after meeting your other expenses, you would have paid the card issuer $2,019.47 of interest after having made monthly payments of $116.99.

Alternatives to Borrowing From Your 401(K)

Some 401(k) plans allow hardship withdrawals for circumstances like preventing eviction from your apartment or making needed repairs to your home. If you take a hardship withdrawal, you will pay federal and possibly state income taxes on the amount you withdraw as well as a 10% federal tax penalty if you are not yet 59½.

You might also consider borrowing money from a bank or a relative. And if you owe a lot of money, you could consult with a credit counselor to find ways to help you get out of debt. As a last resort, you might decide to hire a bankruptcy attorney to wipe out your debt while preserving your 401(k) and other retirement money.

The CARES Act and 401(k) Loans

The Coronavirus Aid, Relief, and Economic Security (CARES) Act, which became law on March 27, 2020, enables people who had taken out a 401(k) loan to delay for up to one year payments owed from that date through December 31, 2020. Interest would still accrue on your outstanding balance during the period of delayed payments.

The CARES Act also eliminated the 10% federal tax penalty on early withdrawals (not loans) made from your 401(k) through the end of 2020.

The CARES Act enabled employers to increase the amount of a loan employees could take against their 401(k) to $100,000 or the entire vested portion of their account, whichever was lower. However, that ability expired on September 22, 2020, and the maximum loan amount returned to $50,000 or 50% of the available amount.

To be eligible for any of the provisions of the CARES Act, you, your spouse, or your dependent must have been diagnosed with the coronavirus or its associated disease (COVID-19) using a test approved by the Centers for Disease Control and Prevention. You must also have experienced financial hardship for one of the following reasons:

  • You were quarantined, furloughed, or laid off or your work hours were reduced due to the coronavirus or COVID-19.
  • You were unable to work because of a lack of child care due to the coronavirus or COVID-19.
  • You closed or reduced the hours of a business you owned or operated due to the coronavirus or COVID-19.

If you are able to repay a distribution taken under the CARES Act within three years, you can get refunded the standard federal income tax you paid on the distribution by filing updated returns.

Article Sources

  1. Fisher Investments. "401(k) Loans FAQs for Employers." Accessed Sept. 25, 2020.

  2. Commerce Bank. "Prime Rate Update." Accessed Sept. 25, 2020.

  3. Internal Revenue Service. "Coronavirus-Related Relief for Retirement Plans and IRAs Questions and Answers." Accessed Oct. 6, 2020.