401(k) Loans: Should You Borrow From Retirement?

When you need a loan, sources like banks, credit unions, online lenders and finance companies immediately spring to mind.

But, for American workers who have a 401(k) plan, there’s another possibility – borrow from yourself.

A 401(k) plan is a workplace program that you contribute to for retirement savings. You don’t open a 401(k) plan thinking you will tap into it before you retired.

However, life happens, and borrowing from your retirement account is an option with its own set of advantages and potential pitfalls.

Should you, do it? There are enough variables that it’s probably wise to get some expert advice from a nonprofit credit counseling agency. More on that later. But first, let’s look at how 401(k) loans work.

Although not every employer-provided 401(k) retirement plan allows participants to borrow from their accounts, most do. Typically, you may borrow up to $50,000 or 50% of your assets (whichever is less), and the loan is tax-free. That money, plus interest, must be returned to the 401(k) plan in quarterly payments in a set time (usually five years).

Unlike bank or consumer loans, the interest payments aren’t a borrowing expense or loss, because they reflect the amount the 401(k) plan would have grown had it been left alone. As a result, the cost to the borrower is less than the cost of paying back a typical loan. You must follow certain rules to avoid being taxed on what you borrow.

401(k) Loan Rules

Interest rates, taxes and fees are considerations in deciding to take out a 401(k) loan.

Interest Rates

A 401(k) loan interest rate is usually a point or two above the prime rate. The current prime rate is 8.25%, so your 401(k) loan rate would be from 9.25% to 10.25%.

Your credit score doesn’t affect the interest rate, which is one reason why so many people find 401(k) loans appealing. According to the Employee Benefit Research Institute, 16% of people eligible for 401(k) loans have loans outstanding.

Although you are paying the interest to yourself instead of someone else, that doesn’t mean there is no cost involved. While your money remains in your 401(k) account, it accrues compound interest, which means you earn interest on the interest you previously earned. The more money you take out for a loan, the less your account will appreciate.

Paying yourself interest allows your retirement account to stay on track. If you keep up with your payments, you’ll still have a balance around what you would have had, if you had kept your hands off the nest egg.

The difference is you had to pay extra out of pocket to build that balance, instead of sitting back and reaping profits from the market.

Taxes

The great advantage of a typical 401(k) is that the money you invest is untaxed until you start withdrawing in retirement. Most of us will have lower incomes by then, thus putting us into lower tax brackets.

If you take a 401(k) loan, there will be major tax implications. Your payments are made with your after-tax income, and your 401(k) will get taxed again when you withdraw during retirement.

If the loan goes into default, you must pay income tax on the remaining balance, and the money can’t go back into a retirement plan. A default becomes more likely if you lose or leave your job before repaying the 401(k) loan because you’ll have less time to repay it. About 86% of workers who leave their job with an outstanding 401(k) loan, go on to default.

Fees

Virtually every financial transaction has fees, including 401(k) loans. Origination fees range from $50-$100. Some come with a maintenance fee that can cost you $25-$50. If the loan is large enough, you might shrug off a fee of $75 or $150. But if you’re only borrowing $1,000, you’re losing up to 15% from the start.

If you default on the loan, there could be a huge fee, depending on your age. If you’re younger than 59½, a 10% early withdrawal fee will apply to the amount you still.

How Much Can Be Borrowed from a 401(k) Loan?

It depends on how much you have in your account. You can borrow up to 50% of your vested account balance, but you can’t borrow more than $50,000. Even if you have a balance of $200,000, the IRS won’t let you touch more than $50,000 of it.

The only time you can borrow more than 50% is when you have a balance of less than $20,000. In that case, you can borrow up to $10,000, even if you only have $10,000 stashed away.

Pros and Cons of 401(k) Loans

Like any financial tool, 401(k) loans have benefits and risks, and you need to determine whether your individual situation makes such a loan advantageous or dangerous.

Potential pros:

• No difficult loan application process. You will need to provide information to your retirement plan administrator, and if you’re married, your plan may require the spouse’s approval to get the loan.
• No impact on your credit score. These loans aren’t reported to the three major credit bureaus, Experian, TransUnion, and Equifax. That could be significant if you’ve had trouble getting a traditional loan.
• No taxes or penalties with a 401(k) loan compared with a 401(k) withdrawal. However, this isn’t the case if you default on the loan.
• Borrowing costs may be lower, and the interest you’re paying is going to back to your retirement account, not to another lender.

Potential cons:

• You may not be able to borrow as much as you need. The most you can borrow is $50,000, and you may not qualify for that.
• No bankruptcy protection. Some debts can get discharged during bankruptcies, not 401(k) loans. If you file for bankruptcy, you’ll face early withdrawal penalties if you don’t repay your 401(k).
• You might get anchored to your current job. If you leave your job, you’ll have to repay your 401(k) loan balance in full by the next year’s tax day (usually April 15).
• Missing out on compound interest while your money is out of the retirement account.
• Defaulting could mean paying significant taxes and fees.

When to Borrow from your 401(k)

Only borrow from your 401(k) when no other reasonable loan rates are available and only if the situation is dire.

By dire, we don’t mean a luxury item. If you’re suffering a medical setback and need cash fast, your 401(k) may be a good place to look. You may even qualify for a hardship withdrawal. In this case you won’t have to pay the loan back, but you’ll still have to pay income taxes, plus the 10% early withdrawal fee.

The qualifications for hardship withdrawal differ from plan to plan. Check with your employer to see what yours may cover.

If you’re looking at your 401(k) as a way out of debt, you’re looking in the wrong direction. Debt (especially credit card debt) is often the result of undisciplined spending or an unforeseen emergency like job loss or medical setback. It’s rarely a one-time purchase that sends the consumer into financial despair.

What Happens to Your 401(k) Loan If You Leave Your Job?

If you lose or leave your job before repaying your 401(k) loan, the IRS will expect you to repay the loan in full by the next tax year. So, if you leave your job in 2023, you’ll owe the entirety of the loan by April 15, 2024, unless you can roll it over into another eligible retirement account.

If you can’t repay it, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That balance would be considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if you’re younger than 59½ or don’t otherwise qualify for an exemption.

How Do 401(k) Loans Impact Your Portfolio?

A worry many have in taking out a 401(k) loan is losing growth their retirement account would have experienced if money hadn’t been taken out. It’s not an unreasonable concern, but it can be overstated. If you handle it appropriately by regularly repaying the funds, the hit to your account shouldn’t be drastic.

A major factor in whether your 401(k) does well or poorly after a loan is the same for every investor – how the market does. If your 401(k) is invested in stocks, market fluctuations will determine whether your portfolio does poorly or well. If the market is strong, the negative impact will be greater because there’s less money to grow. As paradoxical as it may seem, the best time to take a loan is when the stock market is weakening.

Alternatives to Borrowing from Retirement

Dipping into your 401(k) likely will lead to more troubles than it’s worth. There are other ways to get by while keeping your retirement funds intact. Learn more about prioritizing retirement vs paying off debt.

Here are some methods of dealing with a financial emergency:

• Home equity loan – This is a good option for homeowners. It comes with a fixed interest rate that never changes. Right now, the average home equity loan rate is 7.74%.
• A personal loan – Even if the interest is higher than you’d like, it’s often better than interfering with the appreciation of your 401(k). If you have a credit score above 720, you may be able to find interest rates around 10%.
• Nonprofit credit counseling – Maybe you don’t feel comfortable putting your home up for collateral, or your credit is too low for a decent interest rate on a loan. Consider working with a nonprofit credit counseling agency. A credit counselor will take a look at your budget, walk you through your spending habits and help you establish a more manageable financial lifestyle.

A 401(k) is first and foremost a retirement account, not just a second savings or vacation fund. Keep making contributions to your 401(k). Let it sit. Watch it grow. You’ll thank yourself later.

Speak With a Credit Counselor Before Getting a 401(k) Loan

A 401(k) loan isn’t a step to be taken lightly. That’s why credit counseling is a smart first step. A counselor at a nonprofit credit counseling agency can look over your financial situation and help you determine whether a 401(k) loan – or any loan – is what you need right now.

Financial crises often are the result of bad financial habits, and a counselor can identify those and provide solution options. Many of the services offered by nonprofit counseling organizations are free, including the initial consultation.

Speaking with a nonprofit credit counseling agency will give you a clearer picture of where you stand, which provides peace of mind that you’re making the best decision for your future.