A 401(k) is an employer-sponsored retirement savings plan that lets you set aside pre-tax dollars from your paycheck to help fund your years after you stop working. And while personal finance pros don’t recommend raiding your retirement plan for cash if you can avoid it, one major way to tap your 401(k) plan is through a 401(k) loan.
What is a 401(k) loan?
A 401(k) loan allows you to borrow money you’ve saved up in your retirement account with the intent to pay yourself back. Even though you’re lending money to yourself, it’s still treated like a normal loan by charging interest that you’re on the hook for.
When you take out a loan from your 401(k) plan, you’ll get terms like you would with any other type of loan: There’s a repayment plan based on how much you borrow and the interest rate you lock in. According to IRS rules, you have five years to pay back the loan, unless the funds are used to buy your main home, in which case you have more time to repay.
A 401(k) loan has some key disadvantages, however. While you’ll pay yourself back, one major drawback is you’re still removing money from your retirement account that is growing tax-free. And the less money in your plan, the less money that grows over time. Even when you pay the money back, it has less time to fully grow.
In addition, if you have a traditional 401(k) plan, you’ll be repaying the pre-tax funds in the account with your after-tax earnings, so it takes even more – in terms of working hours – to repay the loan.
Risks of taking out a 401(k) loan
Before deciding to borrow money from your 401(k), keep in mind that doing so has its drawbacks.
You may not get one. Having the option to get a 401(k) loan depends on your employer and the plan they have set up. A 2018 study from retirement data firm BrightScope says that 82 percent of plans gave participants the option to borrow. So you may need to seek funds elsewhere.
You have limits. You might not be able to access as much cash as you need. The maximum loan amount is $50,000 or 50 percent of your vested account balance, whichever is less.
Old 401(k)s don’t count. If you’re planning on tapping into a 401(k) from a company you no longer work for, you’re out of luck. Unless you’ve rolled that money into your current 401(k) plan, you won’t be able to use it.
You could pay taxes on it. Your 401(k) contributions are made and grow tax-free until you take distributions. If you don’t repay your loan on time, it could turn into a distribution, which means you’ll end up paying taxes on it.
You’ll have to pay it back more quickly if you leave your job. If you change jobs, quit or get fired by your current employer, you’ll have to repay your outstanding 401(k) balance sooner than five years. Under the new tax law, 401(k) borrowers have until the due date of their federal income tax return to repay in such circumstances.
For example, if you had a 401(k) loan balance and left your employer in January 2022, you’ll have until April 15, 2023 to repay the loan to avoid default and any tax penalty for the early withdrawal, according to The Retirement Plan Company. The old rule called for repayment within 60 days.
Early withdrawals less attractive than loan
One alternative to a 401(k) loan is a hardship distribution as part of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age (59 ½) you’ll typically be hit with income taxes on any gains and may be assessed a 10 percent bonus penalty, depending on the nature of the hardship.
You can also claim a hardship distribution with an early withdrawal.
The IRS defines a hardship distribution as “an immediate and heavy financial need of the employee,” adding that the “amount must be necessary to satisfy the financial need.” This type of early withdrawal doesn’t require you to pay it back, nor does it come with any penalties.
A hardship distribution through an early withdrawal covers a few different circumstances, including:
- Certain medical expenses
- Some costs for buying a principal home
- Tuition, fees and education expenses
- Costs to prevent getting evicted or foreclosed
- Funeral or burial expenses
- Emergency home repairs for uninsured casualty losses
Hardships can be relative, and yours may not qualify you for an early withdrawal.
This type of withdrawal doesn’t require you to pay it back. But it’s a good idea to avoid an early withdrawal, if at all possible, because of the serious negative effects on your retirement funds. Here are a few ways to sidestep those hefty levies and keep your retirement on track.
However, for 2020 only, the CARES Act allows participants to take up to $100,000 (and without a penalty) if they’ve experienced certain COVID-related setbacks. Here are the details.
Other alternatives to a 401(k) loan
Borrowing from yourself may be a simple option, but it’s probably not your only option. Here are a few other places to find money.
Use your savings. Your emergency cash or other savings can be crucial right now — and why you have emergency savings in the first place. Always try to find the best rate on an online savings account so that you’re earning the highest amount on your fundst.
Take out a personal loan. Personal loan terms could be easier for you to repay without having to jeopardize your retirement funds. Depending on your lender, you can get your money within a day or so. 401(k) loans might not be as immediate.
Try a HELOC. A home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow against. You can take out what you need, when you need it, up to the limit you’re approved for. As revolving credit, it’s similar to a credit card — and the cash is there when you need it.
Get a home equity loan. This type of loan can usually get you a lower interest rate, but keep in mind that your home is used as collateral. This is an installment loan, not revolving credit like a HELOC, so it’s good if you know exactly how much you need and what it will be used for. While easier to get, make sure you can pay this loan back or risk going into default on your home.
If taking money from your retirement is your only option, then a 401(k) loan may be right for you. However, try to find other funds first before tapping into this option. Depending on what you need and when you need it, you may have other choices that are better for your situation. Not having emergency or retirement savings are Americans’ biggest financial regrets.