Is Borrowing From Your 401(k) a Good Idea?

Is Borrowing From Your 401(k) a Good Idea?

February 01, 2023

It’s no surprise that more and more people are turning to their 401(k) plans during times of financial hardship. After all, they tend to provide attractive loans at low-interest rates with some leniency on repayment periods - so borrowing from your 401(k) can definitely seem like a sound option.

Some may wonder if they are able to borrow from their 401(k) for use right now. Advice on whether or not to take a loan from your 401(k) is split. Some financial advisers say you should never even consider it. Others think there are certain situations when taking a short-term loan from your retirement savings is not the worst idea.

There are many things to consider when contemplating a loan from your 401(k): the amount of the loan, the length of the loan, the terms and limits of your 401(k) plan, how long you will remain in your current position, and more. Ultimately, it is up to you to determine the best decision.

How a 401(k) loan works

If you are currently enrolled in your company’s 401(k) plan and loans are allowed, you may borrow up to $50,000 or 50% of your vested account balance, whichever is less.

Your vested account balance

Your vested account balance is the money that belongs to you. You are always 100% vested in your contributions, but your employer matching contributions may have different vesting schedules. For example, let’s assume your company matches 2% of the contributions you make to your 401(k) and you are vested after four years of employment.

  • If you take a loan from your 401(k) after year five of your employment, you may take a loan equal to $50,000 or the full 50% of your account, whichever is less.
  • If you take a loan from your 401(k) in year three of your employment, you may take a loan equal to $50,000 or 50% of the money you have contributed to your account, whichever is less. You are not vested in this example and therefore not eligible to consider any of your company’s contributions in the loan.

You can only borrow from plans if you are currently employed

You may only take a loan from the 401(k) plan of your current employer. If you have old 401(k) plans with former employers, you may not take a loan from those accounts.

You repay your loan through payroll deductions

Most 401(k) loans are required to be repaid through payroll deductions. These deductions are taken either quarterly or monthly, and they typically begin as soon as you take the loan. There are some cases where you may have less than 30 days to begin repaying the loan.

You pay yourself back, with interest

The interest rate you pay on 401(k) loans must be “reasonable,” according to the Internal Revenue Service (IRS). In most cases, interest rates are set as prime plus 1%. The total repayment is deposited into your 401(k) account.

You may have to pay taxes on late payments

When you take a 401(k) loan, there is no tax paid on the amount received. But, if you don’t repay the loan on time, any outstanding amounts will be taxed as a distribution and you may be required to pay additional penalties. Under the 2018 Tax Credit and Jobs Act, the final payment of your loan is due the same day your federal income tax return is due.

The cons of taking a 401(k) loan

Most financial experts agree that taking a loan from your 401(k) plan account is not the best idea, especially if you don’t have any other retirement savings. They believe you are jeopardizing your future financial security.

Other disadvantages of borrowing from your 401(k) include:

  • You will take home less money as you repay your loan. Repayments are made through payroll deduction on an after-tax basis. And, if you were struggling to make ends meet before your loan, you may quickly find that your situation has not changed.
  • You may not be able to contribute to the plan while you are repaying your loan. This means you will not only miss out on the compound growth of your retirement investments, but you will also not receive any additional company match.
  • You will need to pay the loan back, in full, if you leave your current employer. If you quit or lose your job while your loan is outstanding, you will be required to repay the full outstanding amount immediately. If you fail to do so, it will be taxed as a distribution, and you may also have to pay penalties for early withdrawal.

If you borrow 401(k) funds to pay everyday debts like your credit card bill, mortgage or rent, you could potentially have a larger problem on your hands. A short-term loan may seem like a good idea but could result in long-term consequences.

The pros of loaning yourself money

If you choose to take a loan from your 401(k) plan, there are some perks.

  • No credit check or minimum credit score required
  • No application needed
  • Low administrative costs
  • Quick access to funds
  • Potentially lower interest rates

You may take up to five years to repay your loan, and there are typically no penalties for prepayment.

When a 401(k) loan may be the right thing to do

While most financial experts do not recommend taking a loan from your 401(k) plan, there are a few situations some consider drastic enough to borrow the money from your 401(k) and pay yourself back.

  • You owe the IRS back taxes.
  • You are in real danger of defaulting on a student loan.
  • You are facing imminent bankruptcy.
  • You are going to be evicted from your home.

Most 401(k) plans also allow for hardship withdrawals, which you do not have to repay. If you are in a situation like one of those listed above and have already maxed out your loan, you may be eligible to take the amount of money needed to pay the debt.

For more information

If you have any questions about your 401(k) plan or the loan features of the plan, be sure to talk to your human resources representative or benefits adviser. They can help you determine whether a loan is your best option and walk you through the process. They can also provide you with further details about a hardship withdrawal if needed. If you'd like guidance on getting started, contact us.

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