If you have a 401(k) plan through your employer and are in need of funds, you may be able to take a 401(k) loan. Borrowing from your 401(k) could provide a path to financial assistance without having to contact other lenders. However, there are also complex 401(k) loan rules and potential drawbacks to consider.
To take out a 401(k) loan, you’ll want to:
— Understand the 401(k) loan rules.
— Know the advantages of a 401(k) loan.
— Think through the drawbacks of a 401(k) loan.
— Weigh your situation carefully before making a decision.
Read on to learn how the 401(k) loan process works and how to decide if borrowing from a 401(k) is right for you.
401(k) Loan Rules
As its name suggests, a 401(k) loan allows you to borrow money from your 401(k) plan and pay it back over time with interest. “Every 401(k) plan is different,” says Laura Morganelli, a financial advisor at CAPTRUST in Allentown, Pennsylvania. “The first step would be to determine what your plan allows.” Some plans offer a loan option but others don’t, so check to see if a 401(k) loan is permissible in your current plan.
The maximum 401(k) loan amount is limited. “401(k) loans are capped at 50% of your account value or $50,000, whichever is lower,” says Ryan Shuchman, an investment advisor and partner at Cornerstone Financial Services in Southfield, Michigan. If 50% of the vested 401(k) account balance is less than $10,000, the account owner may borrow up to $10,000, if the 401(k) plan allows it.
The loan will come with interest that you must pay back to yourself, and you will typically need to repay the amount within five years. This can be different from other loans, such as a mortgage, that might give you 10, 15 or 30 years to repay the amount borrowed. Your monthly or quarterly payments toward the loan will coincide with the five-year timeframe. For instance, if you take a $35,000 loan with a 5% interest rate, your monthly payment could be $660. A longer repayment schedule may be allowed if the 401(k) loan is used to purchase a primary residence.
If you’re unable to pay back the loan within five years, the outstanding amount will be considered a 401(k) withdrawal from the account. “The balance then counts as ordinary income for taxes, plus a 10% penalty,” Shuchman says.
[Read: A Guide to 401(k) Vesting.]
Pros of 401(k) Loans
If you need access to funds, a 401(k) loan may be preferable to an early 401(k) withdrawal. “401(k) loans can be a great alternative to a withdrawal from a retirement account,” Shuchman says. “They are tax-free and the assets can be returned to the account without penalty to continue growing toward long-term goals.” A withdrawal, on the other hand, will be subject to income taxes. If you are under age 59 1/2, you can also typically expect to pay a 10% penalty for an early 401(k) withdrawal. And once you take a withdrawal, the funds will no longer have a chance to grow and earn interest.
Another benefit of a 401(k) loan involves the interest associated with the loan. “The interest paid on the loan is paid back to your 401(k) account,” Morganelli says. If you take out a loan from a different lender, the interest attached to the loan payments goes to the lender. In addition, with a 401(k) loan, you generally don’t need to go through a credit check, which other lenders might require.
Cons of Borrowing From Your 401(k)
Before taking out a 401(k) loan, it can be helpful to think of the long-term picture. “Your 401(k) is for retirement,” says Jason Parker, president of Parker Financial in Silverdale, Washington. If you take funds from it, the account won’t have as many years to earn interest. You may be unable to make additional contributions to the 401(k) account until the loan is repaid, which means you could miss out on a 401(k) match. If you have an emergency fund, it may be better to use those funds rather than the 401(k) plan.
If you take out a 401(k) loan, and then leave your employer before repaying the amount, there could be negative consequences. “If you quit your job or are laid off, the plan sponsor may require the loan to be repaid immediately,” Parker says. “If you are unable to do so, it will be treated as a taxable distribution.” As such, you could lose your job and have to face a high tax event at the same time.
Deciding Whether to Take a 401(k) Loan
If a loan option is available through your 401(k) plan, you’ll be able to repay the loan within five years and you don’t anticipate leaving your place of employment, a 401(k) loan might work out. “The benefit of a 401(k) loan is the ability to access your retirement funds for a short-term cash need in a tax free way, as long as you repay the funds in a timely manner,” says Kenny Senour, a financial planner with Millennial Wealth Management in the Denver area.
Still, if you have other options to pursue, it may be best to leave the funds in your 401(k) account. “By tapping even a small portion of your retirement nest egg early, you run the risk of derailing the progress you have made in saving for retirement in addition to the penalties and taxes incurred if a loan is not paid back,” Senour says.
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