Some 401(k) accounts offer the option of a 401(k) loan, meaning you borrow a portion of your own money that you’ve saved for retirement.
It seems simple at first. Afterall, you’re technically borrowing from yourself. However, 401(k) loans have some serious tax implications if they’re not paid back in the appropriate amount of time. They also have other disadvantages you should consider before getting one.
Why would you take out a 401(k) loan?
A 401(k) loan is not something you take out lightly, because there are huge costs associated with not paying it back on time. Even if you do repay it as planned, you’ll miss out on returns on that money as long as it’s out of your 401(k). You might consider taking out a 401(k) loan if you’re enduring some sort of serious financial hardship.
For example, if you’re facing mounting credit card debt, or are at risk of losing your home, it can be tempting to look at your retirement savings as a way to repair these problems. But Roger Wohlner, a fee-only financial adviser based in Illinois, recommends people look for other debt repayment options before considering taking out a loan against your 401(k). “In my opinion, a 401(k) loan should represent the lender of last resort,” he said.
The reason is, “While most borrowers take these loans with the intention of paying them back, too often this doesn’t happen due to various financial circumstances including a job loss.”
How does a 401(k) loan work?
Generally, the IRS allows you to borrow up to 50% of your vested 401(k) balance or $50,000, whichever is lower. (Limits are lower if you’ve had another 401(k) loan in the last 12 months, but we’ll explain that in more detail later). You have five years to pay back a 401(k) loan, though you may have a longer repayment term if you’re using the loan to buy a primary residence.
The most important 401(k) rule to keep in mind is that if you leave your job, the entire balance of your loan is generally due within 60 days — you’ll want to check the specifics of your plan.
This makes a 401(k) loan riskier than a personal loan and even a credit card. If you leave your job and you have a credit card balance, you can continue making the same payments as before. However, if you leave your job and borrowed $10,000 from your 401(k), you’ll need to pay it back within a short time frame, as dictated by your provider.
Keep in mind that if you cannot pay your 401(k) loan back for whatever reason, your withdrawal will then count as a distribution. If this happens, you may have to pay income tax and a 10% early distribution tax on the outstanding loan balance.
Benefits of a 401(k) loan
There are some potential benefits to taking out a loan against your 401(k).
- Typically the application is brief, and you can complete it at work.
- You can receive the funds in just a few days.
- You can borrow it for any reason
- There is no credit check
Downsides of a 401(k) loan
There are more cons than pros when it comes to thse loans. Here are some examples from research published by certified financial planners (CFPs) in the Journal of Financial Planning:
- Many plans will charge you origination and quarterly maintenance fees when you take out a 401(k) loan.
- If you take money out of your 401(k), that’s money that you’re not investing in the market, which could represent lost investment returns.
- The payments are double taxed. You put money in your 401(k) pretax, but you’ll be making your payments with after-tax income.
- If you leave your job, payments have to be made within 60-90 days, or the loan goes into default.
- If you fail to make your payments, the IRS will consider it a retirement distribution. If you’re under age 59 ½, you’ll have to pay income tax plus a 10% early withdrawal penalty.
- If you have to file bankruptcy, retirement assets are 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 from bankruptcy.
What is the interest rate on a 401(k) loan?
The interest rate on these loans vary, but it is typically 1% above the prime rate. The prime rate changes every day, thus the interest rate you could get today on a 401(k) loan might not be the same tomorrow.
How many loans can you take from your 401(k)?
Some 401(k) plans will allow you to take out more than one loan, but there are typically some restrictions.
As previously stated, you’re generally limited to borrowing the lesser of $50,000 or 50% of your vested balance, and the limit will be lower if you’ve taken out another 401(k) loan in the last 12 months. However, if your plan lets you carry more than one loan at a time, you can only borrow up to $50,000 or 50% of your vested balance in total within one year, even if you already made payments on the first loan. Making payments on the first loan will not “free up” more money to take out in a second loan. You have to wait until 12 months from the first loan in order to once again borrow up to the maximum limit.
Overall, there are more cons than pros to taking out a 401(k) loan. There are often better alternatives when it comes to borrowing money, like a HELOC or personal loan, that won’t put your retirement funds at risk. Still, in extreme financial situations where only high interest loans serve as an alternative, taking out a loan against your 401(k) might be your best choice so long as you repay it quickly and prevent it from being counted as a distribution.