- Introduction
- What is a 401(k) loan and how does it work?
- Pros and cons of 401(k) loans
- Alternatives to a 401(k) loan
- The bottom line
- References
Pros and cons of taking out a 401(k) loan
- Introduction
- What is a 401(k) loan and how does it work?
- Pros and cons of 401(k) loans
- Alternatives to a 401(k) loan
- The bottom line
- References
Life happens, and sometimes you find yourself in a real cash crunch. If you’ve already tapped your emergency funds, a 401(k) loan could be your friend.
A 401(k) loan can be less expensive and easier to obtain than some other options. But 401(k) loans still come with potential risks, so you have to vet the pros and cons.
Key Points
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- In some cases, borrowing from your 401(k) can be a convenient option (there’s no credit check, and you don’t owe taxes on what you borrow).
- You do have to repay yourself—with interest—which helps your retirement stay on track.
- If you leave your job, you’ll have to repay the loan in full within a short period.
What is a 401(k) loan and how does it work?
In the good news category, a 401(k) loan is pretty straightforward. As long as your workplace plan permits these loans, you can generally borrow up to 50% of the balance in your account, or up to $50,000, whichever is lower. (If your vested balance is less than $10,000, you can borrow up to $10,000.)
For example, if you have a balance of $60,000 in your account, the maximum you could borrow would be 50% or $30,000.
You typically begin paying yourself back right away. Most employers set up automatic deductions from your paycheck until the loan is repaid.
You don’t need a credit check to qualify (in fact, the loan won’t be listed on your credit report), so you can often get the money quickly. And unlike a hardship withdrawal, where you have to meet certain criteria to take money from your savings, you can take out a 401(k) loan for any reason.
That said, there are restrictions:
- You have to repay the loan, with interest, typically within five years (unless you use the money to buy your primary residence). But the good news is that you’re essentially paying the interest to your future self.
- Depending on the requirements of your plan, you may have to get the consent of your spouse to take out a loan.
- If you leave your job for any reason, you’ll have to repay the entire balance in full quickly (typically within a year).
- If you can’t repay the loan, you’ll owe interest and taxes on the unpaid loan balance—and a 10% penalty if you’re younger than 59 1/2. That said, because these loans aren’t on your credit report, your score would be spared if you default.
New for 2024: A $1,000 penalty-free 401(k) loan
The 2023 SECURE Act 2.0 will allow, beginning in 2024, a penalty-free loan of up to $1,000 from your 401(k) or IRA, once per year. You can, but should you?
Calculating 401(k) loan interest. Your plan administrator has the ultimate say regarding the interest rate on your repayment. However, it’s typically set at 1% or 2% above the prime lending rate. So, for example, if the prime rate is 7% (the going rate in late 2022), your plan may require you to repay your 401(k) loan with 8% interest.
Use the 401(k) loan calculator in the sidebar to check your monthly payment. For example, if you borrow $20,000 over five years at an 8% annual interest rate and make monthly repayments, your employer would deduct $417.43 each month. Over the five years, you’d pay $5,045.65 in interest (to your future self, of course).
But note: Some plans may require you to pause your contributions while you’re repaying the loan. Be sure to ask about this requirement, because if you can’t contribute to your own retirement for up to five years, that could take a real toll on your savings trajectory.
Pros and cons of 401(k) loans
In some ways, a 401(k) loan might seem like a sweet deal, especially if you’re in a tight corner moneywise. But it’s important to consider all the advantages and disadvantages. These loans have convenience on their side, but the most important factor you have to weigh as a potential borrower is the real cost to you if you can’t repay the loan on time and in full.
| PROS | CONS |
|---|---|
| Easy to obtain, no credit check needed. | If you leave your job, you typically have to repay the balance in full, right away. |
| Funds can be used for any purpose. | If you cannot repay the loan, you’ll owe taxes, interest, and (for those under 59 1/2) a 10% penalty on the unpaid balance. |
| No taxes or penalty on the loan amount, unless you default. | Although you repay yourself with interest, you miss out on market returns on the borrowed amount, which could be higher. |
| You pay yourself back with interest, which helps keep your retirement on track. | Some plans don’t allow you to make contributions to your 401(k) while you’re repaying the loan. |
| If you default on the loan, it won’t impact your credit score. | If you default on the loan, it becomes an uphill battle to replace the lost retirement funds and the lost time in the market. |
Alternatives to a 401(k) loan
Given the potential financial risks of taking out a 401(k) loan, there are a couple of other options you can consider if you need to access your retirement savings.
- Hardship withdrawals. Many 401(k) and other workplace plans allow withdrawals when you’re in dire straits (such as a permanent disability, foreclosure, medical bills that exceed 7.5% of your adjusted gross income, and certain funeral expenses).
A hardship withdrawal counts as a distribution, so you don’t have to repay it, as you would with a loan. You typically avoid the 10% early withdrawal penalty, but you still have to pay taxes. Be sure to ask for details from your plan administrator. - Substantially Equal Periodic Payments (SEPP). If you’re under 59 1/2, you can avoid paying a 10% early withdrawal penalty (but not taxes) by taking scheduled withdrawals from an individual retirement account (IRA) and not a 401(k), (unless you’ve already left your job) according to terms set forth by the IRS.
The difficulty with an SEPP plan is that once you set it in motion, you’re locked into that specific withdrawal schedule until you turn 59 1/2, when you’d qualify for regular withdrawals (or five years after you started withdrawals, if you began after age 54 1/2). If you set up an SEPP plan starting at 50, maybe during a career transition, you’d end up taking withdrawals for almost a decade—which would take quite a bite out of your nest egg. - The rule of 55. Under an IRS guideline known informally as the rule of 55, you can take penalty-free withdrawals from a workplace retirement account—like a 401(k) or 403(b)—if you leave your job for any reason the same year you turn 55 or older. As usual, restrictions apply, but if this scenario applies to you, you can read more about the rule of 55 here.
The bottom line
A 401(k) loan offers ease and convenience, especially if you’ve tapped out other options, but it’s not a move to make lightly. Before you take out a 401(k) loan, the most important question to ask is whether you can stick to the repayment schedule.
The loan itself is easy enough to get, assuming your plan allows it. But the short- and long-term costs of defaulting are hefty. Your future self will thank you for weighing this choice with extra care.
References
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- Considering a Loan from Your 401(k) Plan? | irs.gov
- Retirement Plan FAQs Regarding Loans | irs.gov
- Retirement Topics: Hardship Distributions | irs.gov