Banking 101: 401(k) Loan - Should You Take a Loan Against Your 401(k)?
Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.
Do you need to borrow money but don’t want to deal with a high-interest credit card or personal loan? If you’ve been saving for retirement with a 401(k) plan through work (and your plan allows it), taking a loan from your 401(k) can be a low-cost way to borrow money from yourself and pay yourself back — with interest.
However, 401(k) loans aren’t risk-free. They have some serious tax implications if they’re not paid back in the appropriate amount of time. Read on to learn more about how to get a 401(k) loan, and the pros and cons of this type of loan.
How does a 401(k) loan work?
Some (but not all) 401(k) plans allow participants to borrow their own money from the plan and repay the loan through automatic payroll deductions. 401(k) loans are usually easier to get than personal loans or home equity loans because the application is short and there is no credit check.
Like most loans, when you borrow money from a 401(k), you’ll have to pay interest on the amount borrowed. The plan administrator determines the interest rate, but it must be similar to the rate you’d receive when borrowing money from a bank loan. Any interest charged is repaid to the participant’s own retirement plan.
Pros of taking out a 401(k) loan
There are some potential benefits to taking out a loan against your 401(k):
- Easy application process. Typically, the application for a 401(k) loan is brief. You don’t need to provide a bunch of details about your income, assets and other debts like you do on other loan applications. The Society for Human Resource Management has a sample 401(k) loan application if you want to see the types of questions typically asked.
- No credit check. 401(k) loans don’t require a credit check, so having poor credit won’t impact your interest rate or your ability to qualify for the loan. Plus, applying for the loan won’t result in a hard inquiry on your credit report, which can cause a temporary drop in your credit score.
- Fast funding. In most cases, once you’ve authorized the loan, the fund will be included in your next paycheck or direct deposited into your checking account within a few days.
- Borrow for any reason. Unlike some loans, you don’t need to explain why you need the money or how you plan to spend it.
- No penalty for early repayment. If you have the means to pay off your loan early, you won’t be penalized for doing so. Some home equity loans and home equity lines of credit have prepayment penalties that penalize borrowers for paying off a loan early.
- Pay yourself interest. The interest you pay on a 401(k) plan isn’t paid to the plan, the plan administrator or your employer. Since you’re borrowing your own money, the interest you pay is added to your own retirement account.
Cons of taking out a 401(k) loan
Despite the pros listed above, there are many reasons to think twice before taking out this type of loan. Here are some of the potential pitfalls of taking out a 401(k) loan:
- Pay tax twice on interest. Your original 401(k) contributions were made with pr-tax money. Under normal circumstances, you would only have to pay taxes once you start making withdrawals in retirement. However, your loan repayments, including interest, are made with after-tax dollars. This means you’re paying taxes on the money used to repay the loan, then paying taxes on the interest portion of your loan payment again when you take distributions in retirement. This negates some of the benefits of paying yourself interest on the loan.
- Missed retirement contributions. Some plans do not allow participants to make plan contributions while they have a loan outstanding. If it takes five years to repay your loan, that could mean five years without saving for retirement.
- Missed employer matching money. If your employer offers matching contributions and you aren’t allowed to contribute to the plan while you have a loan outstanding, you’ll miss out on free money.
- Missed investment returns. While your money is loaned out, that’s money you’re not investing in the market. While you’ll earn interest on the loan, in a low interest-rate environment, you could potentially earn a much better rate of return if the money was invested in your 401(k).
- Fees. Many plans charge origination fees and quarterly maintenance fees, which can dramatically increase the cost of taking out a 401(k) loan.
- Tax consequences if you leave your job. If you receive a better job offer, are laid off or fired, you could be required to pay your loan back in full or face serious tax consequences. Starting in 2018, employees who leave their jobs with an outstanding 401(k) loan have until the due date for filing their tax return for that year, including extensions, to repay the loan or roll it over into another eligible retirement account. If you can’t repay the loan or roll it over, your employer will treat the unpaid balance as a distribution. That amount is considered taxable income, and if you’re under age 59½, you may also have to pay a 10% early withdrawal penalty.
- Lost bankruptcy protection. If you have to file for bankruptcy, retirement assets are typically protected. However, if you deplete your retirement accounts with a 401(k) loan and later file for bankruptcy, the money you borrow isn’t protected.
How to get a 401(k) loan
The process for getting a 401(k) loan varies based on the plan’s rules and the plan administrator’s procedures, but here are some general guidelines to help you get started.
- Find out whether your 401(k) plan permits loans. The first step is to talk to someone in your employer’s benefits department or review the summary plan description to confirm that your plan allows participants to take out a loan.
- Request a loan through your plan website. Most 401(k) plans now allow participants to request a loan through the same site you use to manage your 401(k) contributions and investment allocations. You’ll need to specify the amount you want to borrow, and your interest rate and payroll deductions will typically be calculated automatically. If you can’t find the option to request a loan online, talk to someone in your human resources department or call the plan administrator at the number provided on the site.
Once you’ve authorized the loan, you will typically receive the funding in your next paycheck or through direct deposit.
401(k) loan rules: Borrowing from your account
401(k) loans may be easy to get, but they come with a lot of rules. Here are some that you should be aware of.
Each 401(k) plan is allowed to set its own limits for how much participants can borrow, but by law, loans cannot exceed 1) the greater of $10,000 or 50% of your vested account balance, or 2) $50,000, whichever is less. Some plans establish loan limits that are lower than those prescribed by the IRS, and may also set a minimum loan amount.
Employees generally have up to five years to repay a 401(k) loan, although the term may be longer if the money is used to buy a home. IRS rules require 401(k) loans to be repaid in “substantially equal payments that include principal and interest and are paid at least quarterly.” Most plans require that employees repay their loans through payroll deductions.
Like most loans, when you borrow money from a 401(k), you’ll have to pay interest on the amount borrowed. The plan administrator determines the interest rate, but it must be similar to the rate you’d receive when borrowing money from a bank loan. Typically, that means the interest rate is one or two percentage points over the current prime rate.
If you’re married, you may have to get your spouse to agree in writing to your 401(k) loan. This is because, in the event of a divorce, your spouse may have a right to a portion of your retirement funds.
How to pay off a 401(k) loan early
It’s possible to pay off a 401(k) loan early. However, doing so may be tough logistically. When you take out the loan, you agree to repay it in installments that are deducted from your paychecks. That makes it difficult to pay a little extra here and there like you can with a credit card payment or car loan.
Some plans require you to pay the balance in full if you want to prepay the loan. If you have the means to pay the remaining balance in full, talk to your plan administrator to get instructions for the payoff.
Alternatives to 401(k) loans
When cash is tight, borrowing from your 401(k) loan may seem like a good idea. But before you do, consider these alternatives.
Home equity loan or line of credit
If you have equity in your home, a home equity loan or home equity line of credit may allow you to tap your home’s equity at a low interest rate. However, the application and approval process for these types of loans typically take longer than borrowing from a 401(k), so they may not be a good alternative if you need cash right away. Also, keep in mind that for both types of loans your home is used as collateral, which means you could lose your property if you can’t pay back your loan.
0% intro APR credit card
If you have good credit, credit card companies may offer you a 0% interest introductory rate when you open a new account. This may be a good alternative to a 401(k) loan since you won’t have to pay the credit card balance in full if you lose your job. However, watch the terms. Annual fees and high interest rates once the introductory offer expires can significantly increase the cost of borrowing, so you’ll want to be prepared to pay off your balance in full before the promotional period ends.
A personal loan may allow you to borrow the money you need without sacrificing your retirement savings or running the risk of having to pay the balance off right away if you lose your job. However, personal loans usually involve stricter credit requirements, so you may have a harder time getting approved if you have poor credit. Also keep in mind that, unlike with a 401(k) loan, you’ll be paying interest to the lender instead of back to yourself.
The bottom line
Overall, there are more cons than pros to taking out a 401(k) loan, so you should consider the alternatives before putting your retirement savings at risk. If you find yourself in a really tough spot where high-interest loans are the only alternative, taking out a loan against your 401(k) might be your best choice. Just make sure you do whatever it takes to repay the balance quickly and avoid having your loan treated like an early retirement plan distribution.