A loan from your 401(k) may sound like just the ticket to solving a current financial crisis you’re facing. However, it’s not as cheap as you may think, and a lot of factors might make it your worst choice. Before jumping into this decision, arm yourself with the necessary knowledge to make an informed choice.
One of the many benefits available for employees is a company-matched retirement plan, named after the part of the tax code authorizing it. These tax-deferred retirement accounts are the main workplace retirement vehicle for roughly half of private-sector workers in the United States, most commonly through 401(k)-style plans. Many plans now automatically enroll employees at around 4–6% of pay, but actual savings tend to be higher. Recent data show workers contributing around 9–10% of pay, with total 401(k) savings (employee plus employer match) averaging about 14% of pay.
A lesser-known aspect of 401(k) plans is the ability for account holders to borrow against their accumulated savings. Most 401(k) plans allow loans — recent studies suggest around 80% of plans include a loan feature, covering roughly 85–90% of participants.
If your plan allows loans, IRS rules generally let you borrow up to 50% of your vested balance, capped at $50,000. Some plans also offer a minimum loan amount up to $10,000 even if 50% of your balance is less than that.
Most loans must be repaid, with level payments at least quarterly, within five years, although loans used to purchase a primary residence can have longer repayment terms if your plan allows.
Despite these benefits, borrowing against a 401(k) has some significant risks, including severe penalties for non-repayment and the inherent danger of depleting one's retirement nest egg. It’s a decision that should not be made lightly.
As with most financial moves, there are benefits and disadvantages to borrowing from a 401(k). Before you make this move, ask yourself these questions:
Will the money fix the problem?
Many borrowers use money from their 401(k) to pay off credit cards, car loans, and other high-interest consumer loans. On paper, this might look like a good decision. The 401(k) loan likely has a lower interest rate than a consumer loan that probably has a relatively higher interest rate. Paying them off with a lump sum saves interest and financing charges.
But the question of whether repaying that loan will fix the underlying problem remains. Take a look at your last six months of purchases. If you had made a 401(k) loan six months ago and paid off revolving debt, would your debt load still be a problem? Perhaps not — your current situation may reflect an emergency or an unplanned expense. On the other hand, if your credit cards are financing a lifestyle that is above your means, you may find yourself back in the same position a year down the road — and with no money in your 401(k).
Borrowing against a 401(k) to deal with a medical bill, a first-time home purchase, or an emergency car repair can be a smart move. Using a 401(k) loan to put off a serious change in spending habits is, as one financial expert put it, “like cutting off your arm to lose weight.” Before you borrow against your future, make sure it will really fix your present.
Will the investment offer a better return?
Your 401(k) is earning money for you. It’s invested in stocks, bonds, and mutual funds that are appreciating, usually at a fairly conservative pace. If you pull money out in the form of a 401(k) loan, that steady growth stops.
If you’re borrowing from your 401(k) to invest in a business, ask yourself if your new venture will beat the return you’re currently getting. If you’re planning to pay off your mortgage, compare the interest rate you’re paying to that return. Don’t worry about trying to time or forecast the market. For back-of-the-envelope math, many planners use a 4 to 6% annual return assumption for a diversified 401(k) portfolio. You don’t need to forecast the market perfectly, but you should compare that potential growth to whatever you plan to do with the borrowed money.
Is your job secure?
If you’ve recently been promoted or gotten new training on an important job duty, you can be reasonably confident you aren’t going to be let go from your job any time soon. If your recent performance reviews haven’t been stellar, or if your company has some layoffs pending, you might want to beware. If you’re at all hesitant about your future at the company, hold off on borrowing from a 401(k).
If you leave your job with a 401(k) loan outstanding, many plans will require you to repay the remaining balance within a short window. If you don’t, the unpaid amount is usually treated as a loan offset, which is reported as a taxable distribution.
You’ll generally owe income tax on that amount, and if you’re under age 59½ and don’t qualify for an exception, you may also face a 10% early-withdrawal penalty. However, current rules allow you to avoid taxes and penalties by rolling over an amount equal to the loan offset to another eligible retirement account by your tax filing deadline (including extensions) for that year.
All things considered, staring down big bills like that after you’ve just lost your job is not a fun predicament. Because leaving your job with an outstanding loan can create tax and repayment headaches, be reasonably confident in your job stability and repayment plan before borrowing, and have a backup strategy in case you leave sooner than expected. You may also want to consider accelerating your repayment plan to get your 401(k) refunded as quickly as you can. Unlike some loans, there’s no penalty for early repayment. Plus, the sooner the money is back in your account, the sooner it can start earning for you again.
Do you have other options?
If you’ve identified your need for money as immediate, consider what other options you may have available before you dig into your retirement savings. For home repairs, using your home equity line of credit can be a smarter choice. For an outstanding car loan, refinancing may make more sense. For a medical bill, it may be wiser to negotiate a repayment plan with the hospital.
If you’re purchasing your first home, consider the tax implications of mortgage interest. In many cases, you’ll receive preferential tax treatment for interest paid on a home loan. You won’t receive that same benefit from a 401(k) loan.
Borrowing from a 401(k) can be a good way to solve a short-term financial issue. However, it's essential to be aware of the associated risks and consequences for your long-term financial health. More often than not, exploring alternative solutions will prove to be a wiser course of action.
