If you save in your employer’s 401(k) plan, you may be able to borrow from your balance. While this may seem like an easy source of cash you can access in a pinch, there are many reasons you may want to avoid doing so.
What Is a 401(k) Loan?
Although 401(k)s are intended to provide you with a tax-advantaged way to save for retirement, you are also permitted to take out loans against your balance. Even though you are borrowing the money from your own account, it is a formal loan, complete with a structured repayment plan and interest charges.
How Does It Work?
To borrow money from your 401(k), you’ll need to submit a loan request to your plan administrator. You may be able to do it online by logging into your account, or request a paper application from HR.
There is a limit on how much you can borrow at any given time. Per IRS regulations, you are only able to borrow the lesser of 50% of your vested balance or $50,000. One exception is that you can always borrow at least $10,000, even if that is more than 50% of your vested balance. However, understand these are the maximums allowed by law. Your employer may have their own rules that are more restrictive.
The interest rate you pay will typically be lower than what you’d get on a credit card or personal loan. In most cases, the loan term can be up to 60 months but can be longer if you are borrowing to purchase your primary residence.
Reasons You May Want to Avoid Borrowing From Your 401(k)
401(k) loans are often pitched as an easy way to access your own money. Some people even think of them as “free” because the interest you pay goes back into your own account. However, there’s more to it than that, and you need to consider the downsides.
The Loan Balance Doesn’t Benefit From Investment Growth
One of the main benefits of saving money inside your 401(k) is that you can invest it. Those investments then receive dividends, interest, and capital gains — the source of the compound growth that allows you to accumulate a healthy retirement nest egg.
When you borrow from your 401(k), the debt balance is no longer invested. You’ll lose out on the growth that money would have earned. This could represent a significant opportunity cost that puts your retirement at risk.
It Isn’t a Free Loan
Perhaps the biggest misconception about 401(k) loans is that because you are paying yourself, the interest isn’t really an expense. However, it still represents an actual hit to your cash flow. Just like the payment you’d make on a personal or car loan, you need to be sure that you can afford the payments without putting too much strain on your monthly budget.
You May Be in a Bind If You Change Jobs
Although you have five years to repay your loan, that assumes you stay put. If you leave your job for any reason, you’ll be required to pay the remaining loan balance in full, which could be difficult to do.
If you can’t repay the loan, the balance will be treated as a distribution, subject to taxation at your ordinary income tax rate.
You Don’t Actually Need the Money
Think about the reason you want to borrow money in the first place. Is it to buy a new car? Pay for a vacation? Be careful to avoid using your 401(k) money for nonessential consumer spending. Borrowing from your 401(k) to buy things you don’t need or can’t afford is just as harmful as running up a large credit card balance. Don’t look at it as an easy source of cash for casual spending.
Taxes and Penalties for Failing to Pay
You can borrow from your 401(k) tax-free. That’s because you aren’t withdrawing the money. If you pay it back, you will continue to benefit from tax deferral. However, if you can’t pay it back, it becomes a taxable distribution. Remember, your payment schedule could be accelerated if:
- You lose your job: The loss of income will probably make paying the loan balance off even more difficult.
- You change jobs: Imagine being offered a better job but being unable to take it because you can’t afford to pay back your 401(k) balance.
In addition to owing taxes at your marginal rate, you’ll also be subject to the 10% early withdrawal penalty if you’re under 59&½.
You May Not Be Able to Make Regular Contributions
Borrowing from your 401(k) may limit your ability to continue making your normal contributions for several reasons.
- Some employer plans restrict your ability to make regular 401(k) contributions while you have an outstanding loan.
- If your budget is too tight, you may simply not be able to continue making your ordinary contributions while your loan is active.
Whatever the reason, if you can’t continue making contributions to your 401(k) plan, you’ll miss out on any matching contributions that you would have otherwise received.
Payments Are Not Tax Deductible
Unlike 401(k) contributions, 401(k) loan repayments aren’t tax deductible. That means you’ll have to first pay taxes, and then make loan payments from your net income.
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When Could a 401(k) Loan Make Sense?
Although it’s generally best to avoid them, there are times when a 401(k) might be the best option you have.
Inadequate Emergency Savings
Although it is best to set aside savings specifically for emergencies, the reality is you may find yourself without enough. Things like home and auto repairs or medical expenses are reasons you may want to borrow from your 401(k).
Debt Consolidation
If you’ve got high-interest credit card debt that you are starting to lose control of, a 401(k) loan may help you get things back in order. Borrowing from your 401(k) to consolidate high-interest debts could prevent things from spiraling.
Down Payment on a Home
Owning a home allows you to build equity and can provide stability. Using a 401(k) loan to cover part of a down payment or other closing costs may provide the means to do that.
Pros and Cons of 401(k) Loans
Pros
- Because there is no outside lender, 401(k) loans are easier to qualify for.
- Interest rates are lower than what you’d get on a personal loan.
- Unlike withdrawals, loans are tax-free.
Cons
- Your loan balance doesn’t benefit from investment growth.
- Taxes and penalties may apply if you fail to repay your loan.
- You may not be able to continue making regular contributions.
- Your retirement savings could come up short.
- If you leave your job, you’ll have to pay off your remaining balance quickly.
- IRS limits restrict the amount you can borrow.
Alternatives to 401(k) Loans
If you find yourself considering a 401(k) loan, think about the other options you might have access to. Most of the time, a 401(k) loan should be your last resort.
Personal Loans
Most financial institutions offer personal loans. These are typically unsecured, and you can use the money for any reason. You’ll need to qualify, and you’ll likely pay a higher interest rate, but you won’t have to sacrifice the potential growth on your 401(k) balance.
Personal loans can also be an effective way to consolidate debt. If you have multiple high-interest debts, such as credit cards, taking out a personal loan with a lower interest rate can simplify your payments and potentially save you money.
Debt consolidation loans are specifically designed for this purpose, allowing you to combine all your debts into a single loan. This can make managing your finances easier while reducing your overall interest burden. However, you should still compare interest rates and fees carefully, as personal loans can vary significantly depending on the lender.
Home Equity
If you own your home, there are several ways you can borrow against the equity, such as home equity loans or lines of credit. Because they are secured by the equity in your home, you may pay a lower interest rate than you would on a personal loan. The loan terms are often much longer as well, reducing your monthly payments.
Introductory Credit Cards
It’s not uncommon for credit cards to offer introductory rates on new cards. You’ll often see credit cards offer 0% interest rates for the first year. You need to be especially careful if you go this route, but if you have a good plan for paying the balance off before the introductory period is over, this may be a good choice.
Key Takeaways
- Borrowing from your 401(k) can seem like a quick solution, but it comes with significant risks, including lost investment growth and potential tax penalties.
- Consider alternatives like personal loans, home equity loans, or even 0% interest credit cards before tapping into your retirement savings.
- A 401(k) loan could make sense in emergencies or to consolidate high-interest debt, but it should always be a last resort.
