When you face a financial need such as a major home repair, a college tuition bill or an overload of credit card debt, it can be tempting to tap into your 401(k). You may think borrowing your own money could be less dangerous than owing money to someone else. Unfortunately, 401(k) loans can create both short- and long-term financial hazards.
Missing out on long-term appreciation can damage your retirement prospects. Short-term, you could trigger tax consequences if you don’t repay your loan according to the rules. Worse, if you leave your job with an unpaid 401(k) loan, your repayment schedule is moved up dramatically.
“While it’s possible under some circumstances to take out a 401(k) loan with minimal impact, our research has found that if you take out one loan, you’re more likely to take out another,” says Katie Taylor, vice president of thought leadership for Fidelity Investments in Smithfield, Rhode Island. “You’re also more likely to decrease your retirement contributions while you’re repaying the loan. It’s the behavior that follows taking the loan that can erode your retirement savings.”
401(k) Loan Details
Technically, a 401(k) loan isn’t a loan, since the only lender involved is you. You’re accessing your retirement funds early and then replacing them — with interest — to replenish your savings.
The IRS and your employer set the rules for borrowing from your 401(k). Companies are not required to offer 401(k) loans, although Taylor says the vast majority do.
IRS rules set a maximum loan amount of 50 percent of your vested balance or $50,000, whichever is less. In other words, if you have $40,000 in your 401(k), you can borrow a maximum of $20,000. However, those with a vested balance less than $20,000 are allowed to borrow up to $10,000.
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Your vested amount includes your personal contributions to your retirement account and the amount of your company match you could access if you left the company today, says Taylor. For example, if your company requires you to stay six years to be fully vested and you left after three years of employment, your 401(k) balance would be limited to your contributions unless the company prorates your vesting, in which case you would have a portion of the company match.
The IRS requires 401(k) loans to be repaid within five years, with a payment plan established at the time you borrow the money. However, repayment can be extended to 15 years, according to your employer’s plan, if the loan was taken out to purchase a house.
While the IRS requires that payments be made at least quarterly, 401(k) plan administrators can establish their own rules. Most people repay the loan with payroll deductions. There are no prepayment penalties on 401(k) loans.
Your contributions to a 401(k) are made with pretax dollars, but your payroll deductions for a loan repayment are made with after-tax dollars.
Unlike other types of borrowing, you aren’t subject to a credit check since you are tapping into your own assets. Most plan administrators set a low interest rate for repayment that is not based on your creditworthiness, typically the prime rate or the prime rate plus 1 percent, says Taylor. In addition, 401(k) plan administrators typically set fees for loans, including origination, administration or maintenance fees, or a combination of fees.
Although IRS rules allow more than one 401(k) loan at a time as long as the combined balance doesn’t exceed the maximum, most plans allow you to take out another loan only after the first loan has been repaid. Taylor says 70 percent of plan sponsors require borrowers to have only one loan at once.
Hardship Distribution or Loan
The IRS also allows the option of a hardship withdrawal from your 401(k) that does not need to be repaid, but you must be able to prove that you need money for a specific purpose as defined by the IRS or your employer’s plan. While you don’t need to repay the money, it will be treated as income, so you’ll pay income taxes on the withdrawal, says Elijah Kovar, a financial advisor and founding partner of Great Waters Financial in Richfield, Minnesota.
“You’re losing the tax-deferred status of the money when you take a hardship distribution,” says Kovar. “You won’t be able to pay it back, either, since you’ll be limited to your annual contribution to your retirement account.”
The IRS prohibits people from contributing to their 401(k) for six months after taking out a hardship distribution, which further erodes the balance of the account. If you’re younger than 59 1/2, you may be subject to a 10 percent tax penalty for an early distribution, according to the IRS.
“Some of the typical reasons for a hardship withdrawal are medical expenses, to avoid eviction or foreclosure, to purchase a house or for tuition-related expenses,” says Kovar.
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A hardship distribution must be approved by your employer, and you’ll have to prove that you don’t have other assets available for the expense.
Risks of 401(k) Loans
The two main drawbacks of 401(k) loans are the consequences if you don’t repay the loan in time and the depletion of your retirement savings.
“The risks of taking out a 401(k) loan outweigh the benefits, so I discourage anyone from doing this as anything other than a last resort,” says Kovar.
The big gamble, says Kovar, is the potential of a job change, which triggers an accelerated repayment schedule of the unpaid balance of a 401(k) loan.
“You can roll over your 401(k) to a new employer, but you can’t roll over a 401(k) loan,” says Kovar.
Until the 2018 tax overhaul, leaving your job meant you had 60 days to repay your loan. If you didn’t pay within that time, the loan was considered a distribution, triggering taxes and penalties. The new tax law extends the repayment period to the due date of your federal income tax return. Any unpaid balance at that time becomes taxable income and can incur an early distribution penalty.
“The worst-case scenario is when someone borrows $30,000 from their 401(k) and suddenly gets laid off,” says Kovar. “Then they have an already precarious financial situation made worse because they owe taxes on the remaining balance and a 10 percent penalty if they’re under 59 1/2.”
Even if you repay a 401(k) loan, it could still be detrimental to your retirement because you’ve lost out on potential market gains while the money is out of your account. Although you repay yourself with interest, the amount of interest you’re paying may not be as much as if you left the money invested, says Taylor.
“Unfortunately, many people cut back on their 401(k) contributions or eliminate them entirely while repaying their loan, which can have a big impact on their overall retirement savings rate,” says Taylor. “If you have to take out a loan, the best guidance is not to decrease your pretax contributions.”
Despite these risks, the percentage of Fidelity’s 401(k) participants with an outstanding loan as of June 30 was 20.5 percent. The average loan amount was $7,700.
Alternatives to 401(k) Loans
While ideally a robust emergency savings account helps you avoid borrowing from your retirement account, other options are also available.
If you’re buying a car or paying tuition, a car loan or student loan typically has a low interest rate, says Kovar.
“Even if the interest rate is a little higher than the interest you’ll pay on your 401(k) loan, you have to factor in the amount of money you’re losing by having that money out of the stock market,” he says.
Borrowing from your home equity with a home equity line of credit or a cash-out refinance is another option to compare with a 401(k) loan and particularly smart if you need the money for a home repair or remodel that will add value to your property. Some financial institutions allow you to borrow using your investments as collateral for the loan, provided you have good credit and substantial assets.
A personal loan or a credit card can also provide funds, although both typically charge higher interest rates than a 401(k) loan or a home equity line of credit.
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If you face a substantial medical bill or owe money to the IRS, you can often arrange a long-term repayment plan so you don’t have to borrow from your 401(k).
“If you have good credit, you may qualify for a credit card with zero percent interest for 18 months,” says Kovar. “If you have the discipline to repay the debt in that time frame, that could be a good alternative to a 401(k) loan.”
When comparing alternatives, keep in mind that a 401(k) loan won’t be reported on your credit report like other choices for borrowing, says Steven Barrett, a financial consultant with Xceed Wealth Management Group, part of the Xceed Financial Credit Union in Los Angeles. However, if you plan to apply for a home loan and have a 401(k) loan, a lender will see that financial obligation and take it into consideration when underwriting a mortgage.
When a 401(k) Loan Might Be a Good Choice
Most financial experts suggest that a 401(k) loan should be a last resort, but there are some circumstances when this type of borrowing could have minimal consequences.
The best scenario for using a 401(k) loan, says Barrett, is for a short-term need that you can repay quickly. The funds from a 401(k) loan can be in your account swiftly.
“A 401(k) loan can be a good financial tool, but only if you look at all of your alternatives,” says Barrett. “One of my clients opted to take out a 401(k) loan to pay his property taxes when he didn’t have the cash available, knowing he would repay the loan in less than a year.”
Modeling the loan terms and comparing your repayment options between a 401(k) loan and a credit card or personal loan could make borrowing from your retirement more attractive, says Barrett, as long as you understand the risk of an unplanned job change that could trigger a tax bill as well an accelerated repayment requirement.
“A 401(k) loan can be a solution to a problem, but it’s important to have a detailed conversation with a financial advisor about what it means and your alternatives,” says Barrett. “It’s OK if you need it to get through a problem like a big medical bill. Just make sure you don’t repeat that problem.”
Making a down payment on a house is a common reason for younger people to take out a 401(k) loan, says Taylor.
“While buying a house can be a good thing, it’s important to borrow only the minimum that you need, pay it back as quickly as you can and continue to contribute to your retirement,” says Taylor.
Mitigating the Risks of a 401(k) Loan
If you decide a 401(k) loan is your only option, Kovar recommends committing to the shortest possible repayment term.
“The faster you repay the loan, the less risk you face of changing your employment status,” says Kovar. “In addition, you’re out of the market a shorter time.”
In addition to evaluating alternative solutions, careful consideration of a repayment plan and a budget that allows you to continue contributing to your 401(k) are essential to minimizing the impact of a 401(k) loan on your financial health.
“For 80 percent of Americans, their 401(k) is their nest egg,” says Taylor. “Don’t enter into this lightly because you are borrowing against your future.”
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