Expanded Lesson
6 min read
What You Should Know Before Taking a Loan from Your 401(k)
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Your 401(k) is your retirement nest egg. You’ll need that money later in life once you have stopped working. If you need extra cash for an emergency or have trouble making ends meet, you may be tempted to tap into your 401(k) before retiring. After all, it’s your money. But withdrawing from your account before you retire may leave you with less money for your golden years. Keep these tips in mind when tapping into your 401(k).
LESSON CONTENTS
What is a 401(k) loan?
Taking out a 401(k) loan is basically like borrowing your own money. You’ll need to pay the loan back with interest, just like any other type of loan. The interest rate is fixed and is usually a few points above the prime rate but may vary. The interest you pay will return to your 401(k) account. These payments are made with after-tax dollars and can be subject to additional tax upon withdrawal in the future. Some plans may allow you to pay the loan back using automatic payroll deductions.
Most employers allow you to borrow from your 401(k) plan, although not every plan does. Check with your employer to see if yours qualifies for this.
How much can you borrow?
The maximum amount you can borrow is typically the lesser of $50,000 or 50% of your vested amount. Depending on your company’s policies, there may also be a minimum amount you’ll need to borrow to get a loan.
Usually, a 401(k) loan is a five-year loan, but you may be able to arrange a shorter term or pay back the loan early. As far as repayment frequency goes, you should make payments at least quarterly, but you may not be required to make a payment every time you get paid. The longer the repayment period, the lower your regular payment will be, but the more you will pay in interest over the life of the loan. Consider shortening the repayment period if you’re trying to limit the amount of interest you pay.
Pros and cons of borrowing from your 401(k)
Pros:
- You won’t have to explain what the money is for.
- You typically won’t have to pay taxes and penalties on a 401(k) loan (withdrawals are different).
- The interest you pay goes back into your retirement account.
- If you miss payments or even default on the loan, it won’t affect your credit score.
Cons:
- Should you default on the loan, it will be considered a withdrawal. These are subject to taxes, plus a 10% penalty if you are under 59 ½.
- You may lose out on investing the money you borrow in a tax-deferred account.
- Fees may be higher than getting a loan from a bank.
Be Aware
Should you leave your job, you’ll have to pay back the entire amount within a specific timeframe, usually 90 days. If you don’t pay it back, it’s considered a withdrawal, and you’ll be required to pay taxes and a 10% penalty.
Hardship withdrawals
If you’re looking to borrow against your 401(k) in the event of an emergency, you might qualify for what’s known as a hardship withdrawal or hardship distribution. The amount you can withdraw is limited to the amount of the necessary expense, which means you can’t withdraw money for non-essential purposes. Consumer purchases are not usually counted as a legitimate need. According to the IRS, qualifying hardships can include:
- Medical expenses not covered by insurance.
- Funeral expenses.
- Tuition.
- Down payment or repairs on a primary place of residence.
- Threat of foreclosure or eviction.
- Court-ordered child support.
While these withdrawals may come in handy, you should only think of them as a last resort. You’ll need to get approval from your employer before making a withdrawal. Some companies will even bar you from making contributions six months after the withdrawal. You will also have to pay taxes on the withdrawal and may need to pay the 10% penalty if you are under the age of 59 ½.
Hardship withdrawals are considered distributions, not loans, and therefore cannot be repaid. This means that hardship withdrawals will permanently lower the amount you can contribute for the year since 401(k) plans are subject to limits, currently $19,500 a year for 2021 (although if you’re over 50, you can take advantage of catch-up contributions), leaving you with less money in retirement. You’ll also lose out on potential investment growth. This may seem inconsequential, but if you take a $5,000 disbursement from your retirement account today, it would be worth $38,061 in 30 years, assuming a return of 7% annually.
What are some alternatives to a 401(k) loan?
What if you don’t have access to an employer-sponsored retirement plan or don’t have a large, vested balance? Experts generally caution against borrowing from your 401(k) unless it’s an absolute emergency because it could compromise your retirement savings and leave you woefully unprepared. But you need money, so what should you do?
Here are a few alternatives you could consider.
Experts generally caution against borrowing from your 401(k) unless it’s an absolute emergency because it could compromise your retirement savings and leave you woefully unprepared.
Emergency savings
The average American has a small amount of savings, which is why it’s essential to plan ahead and save for unexpected events. If you have emergency savings, you should use it only if you have a true emergency. If you use it for things that are not emergencies, such as vacations, you may not have enough money when you need it most.
Home equity line of credit or home equity loan
If you own a home, you could apply for a home equity line of credit (HELOC) or a home equity loan. A HELOC is a revolving line of credit and works like a credit card in that you only pay interest on the amount you borrow. Interest rates are typically lower, but the loan is secured by your home, which means it can be used as collateral if you default on the loan.
In contrast, home equity loans are paid out as a lump sum. You’ll pay interest on the whole amount, and there may be penalties if you pay it back early. With a HELOC, you only pay interest on whatever you use, so they’re a bit more flexible.
HELOCs and home equity loans also may have certain loan requirements like minimum home equity and specific debt-to-income ratios. These requirements will vary depending on the lender.
Take a personal loan
Personal loans can have interest rates that are similar to 401(k) loans, although this may vary depending on your credit score and credit history. If you don’t have a strong credit history, getting a personal loan approved or getting a low interest rate may be difficult.
Plan for the next emergency
Financial emergencies can happen to anyone, so start putting aside money now so you won’t have to panic next time. Just $5 or $10 per paycheck will add up over time and can make a big difference.
PLEASE NOTE: The information provided is for educational purposes only and should not be considered recommendations or advice. Please consult the appropriate financial, tax or legal professional to determine whether the strategies presented in this article are appropriate for your situation.
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