If you have a 401(k) plan through your employer and need funds, you may be able to take out a 401(k) loan. Borrowing from your 401(k) provides a path to financial assistance without having to contact other lenders. However, there are complex 401(k) loan rules and potential drawbacks to consider.
Before taking out a 401(k) loan, familiarize yourself with the following points:
— Can I borrow money from my 401(k)?
— What are the requirements for a 401(k) loan?
— How does 401(k) repayment work?
— Pros of 401(k) loans.
— Cons of borrowing from your 401(k).
— Is a 401(k) loan a good idea?
Can I Borrow Money From My 401(k)?
Depending on the rules of your plan, you might be able to borrow from your 401(k). 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. “The 401(k) loan will be processed by the plan administrator and each plan has different rules,” said Ian Weiner, certified financial planner and owner of Bespoke Wealth Solutions in Bentonville, Arkansas, in an email. Check with your provider to confirm if a loan option is available to you under your current plan.
[Read: Should You Use Your 401(k) to Pay Off Debt?]
What Are the Requirements for a 401(k) Loan?
“Not all 401(k) plans allow participants to take loans, whereas others cap the number of loans or the dollar amount a participant can take,” said Julian Schubach, senior vice president of wealth management at New York-based ODI Financial, in an email. Typically, you can take out $10,000 or 50% of the account’s balance up to $50,000. If your balance is $30,000, you might be able to take out as much as $15,000. If you have a balance of $150,000, you could be able to borrow up to $50,000.
How Does 401(k) Repayment Work?
The loan will come with interest that you must pay back to yourself, and most plans require that you repay the loan within five years. This can differ from other loans, such as a mortgage, that might give you 10, 15 or 30 years to repay the amount borrowed. “There will be a pay schedule, a set number of months to repay the loan in full. Plus, the participant generally must pay back the loan with interest,” Schubach said.
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. That amount will be considered ordinary income and will be subject to taxes. You may also have to pay a 10% penalty.
[Read: Is a 401(k) Worth It in 2024? Pros, Cons and Costs]
Pros of 401(k) Loans
If you need access to funds, a 401(k) loan may be preferable to an early 401(k) withdrawal. A withdrawal 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 make a withdrawal, those funds will no longer have an opportunity to grow and earn compound interest. If you repay your loan within the allotted time, you won’t have to pay the 10% penalty.
With a 401(k) loan, “it is easy to access the funds and there is usually a very minimal origination or administrative fee compared to other lending options,” said Kevin Chancellor, CEO of Black Lab Financial Services in Melbourne, Florida, in an email. If you take out a loan from a different lender, the interest attached to the loan payments goes to the lender. Additionally, a 401(k) loan doesn’t require a credit check, which other lenders might.
Cons of Borrowing From Your 401(k)
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. A lower balance also means you are missing out on opportunities for your funds to grow over time.
“If you aren’t making payments toward the loan, any outstanding loan amounts that were pretaxed will be taxable,” Chancellor said. “You may also have to pay potential penalties for early withdrawals if these loans are not paid back on time.”
If you take out a 401(k) loan and then leave your employer before repaying the amount, there could be negative consequences. “If you leave your job before the loan is paid back, you will have to pay back the balance by the due date of your next federal tax return,” Chancellor said. If you aren’t able to pay off the amount, it could be considered a taxable distribution.
[New 401(k) Contribution Limits for 2024]
Is a 401(k) Loan a Good Idea?
If you are confident that 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 could be a sensible option.
Still, if you have other options to pursue, it may be best to leave the funds in your 401(k) account. “The cost of taking money out of a tax-qualified account for an extended period of time can have a dramatic effect on the account’s ability to compound,” Weiner said. There could be additional penalties and taxes too, if you are unable to pay back the loan.
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How to Take a 401(k) Loan originally appeared on usnews.com
Update 04/24/24: This story was published at an earlier date and has been updated with new information.
