The pros and cons of taking out a 401(k) loan

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 time – 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 2022 study from the  Employee Benefit Research Institute and the Investment Company Institute says that 84 percent of plans had outstanding loans based on 2020 data. 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 take a loan on it.
• You could pay taxes and penalties on it. If you don’t repay your loan on time, the loan could turn into a distribution, which means you may end up paying taxes and bonus penalties 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 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 2023, you’ll have until April 15, 2024 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.

Advantages of borrowing from a 401(k)

Borrowing from your 401(k) isn’t ideal, but it does have some advantages, especially when compared to an early withdrawal.

• Avoid taxes or penalties. A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis.
• Dodge credit checks. 401(k) loans also won’t require a credit check or be listed as debt on your credit report. If you’re forced to default on the loan, you won’t have to worry about it damaging your credit score because the default won’t be reported to credit bureaus.

When a 401(k) loan makes sense

Borrowing from your 401(k) should be a rare occurrence, but it can make sense if you find yourself in need of a meaningful amount of cash in the short term. It shouldn’t be used for small amounts or on items that aren’t absolutely necessary. A 401(k) loan is often a better financial choice than other short-term funding options such as a payday loan or even a personal loan. These other loan options typically come with high interest rates that make them less attractive. Plus, a 401(k) loan is relatively simple to arrange compared to applying for new loans with other financial institutions.

Can you pay off a 401(k) loan early?

Yes, loans from a 401(k) plan can be repaid early with no prepayment penalty. Many plans offer the option of repaying loans through regular payroll deductions, which can be increased to pay off the loan sooner than the five-year requirement. Remember that those payments are made with after-tax dollars, unlike contributions, which are made before taxes.

Will your employer know if you take out a 401(k) loan?

Yes, it’s likely your employer will know about any loan from their own sponsored plan. You may need to go through the human resources (HR) department to request the loan and you’d pay it back through payroll deductions, which they’d also be aware of. Loans aren’t guaranteed to be approved either, or your plan may not offer them at all. If you’re concerned about a manager or executive finding out about the loan request, consider asking HR to keep your request confidential.

Early withdrawals less attractive than loans

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.

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 a high-yield savings account so that you’re earning the highest amount on your funds. 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, while 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.

Bottom line

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.