The Pros and Cons of 401(k) Loans

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photo credit: Unsplash/Logan Adermatt

Should You Borrow from Your Retirement Account?

Whether it’s a financial emergency or a big opportunity, sometime in your working life you might need a large sum of money that you don’t have. When that time comes, you might consider a loan from your 401(k) retirement plan — after all, it’s your money — but there are some things to consider before signing the loan agreement.

Are Loans Available?

Not all retirement plans offer loans as an option. Individual Retirement Accounts (IRAs) and Roth IRAs —or IRA-based plans such as Simplified Employee Pension (SEP) plans — cannot give loans. However, if you have a 401(k), 403(b) or 457(b) plan, you might be able to borrow money from your retirement account.

Do You Need a Loan or a Hardship Distribution?

If your employer’s plan provides for hardship distributions, the Internal Revenue Service (IRS) allows you to withdraw funds from your 401(k) under certain circumstances without penalty. Check with your employer to see if they offer hardship distributions for:

  • College tuition and higher education costs
  • Medical bills
  • A down payment or repairs to your home
  • Saving a home from foreclosure or eviction
  • Funeral costs

See the IRS website for more details on hardship distributions and check with your employer about your specific plan.

Know Your Limits

The IRS limits how much you can borrow from your 401(k) to either $50,000 or half of your total amount in the account, whichever amount is smaller. The maximum that anyone can borrow is $50,000. So:

  • If you have $60,000 in your account, you may borrow up to $30,000.
  • If you have $120,000 in your account, you may borrow up to $50,000.

Get Clear on Loan Details

Typically, the maximum term allowed for a 401(k) loan is five years, but could be longer if you are using the money to buy your primary home. The interest rate on a 401(k) loan must be around the same rate that you would receive from a conventional lender such as a bank or credit union. You will need to discuss specific terms with your employer to clarify the details, such as:

  • The principal (how much you are borrowing)
  • The term of the loan (how long you have to pay it back)
  • The interest rate
  • Any additional fees and penalties

Also, keep in mind that if you are married, your spouse might have to give his or her approval before you can take out a loan on your retirement account, even if it is your personal 401(k). Your retirement plan is considered one of your assets, so your spouse could have some legal claim to it in a divorce settlement.

Repaying a 401(k) Loan

Most often your employer will deduct your loan payments from your paycheck, just as they deducted your 401(k) contributions. However, there is a difference – the contributions you made to your 401(k) were pretax, but you will be repaying your loan with after-tax dollars. Later on, when you start to withdraw money from your 401(k) in retirement, your withdrawals will be taxed again.

Pros of 401(k) Loans

  • You don’t have to pay taxes or early withdrawal penalties when you take a 401(k) loan because (in theory) you will replace the money.
  • The interest you pay on the loan ends up back in your account, rather than going to a third-party lender.
  • If you have poor credit, you might be able to get a better interest rate from a 401(k) loan than from a traditional lender.

Cons of 401(k) Loans

  • It can take a long time to rebuild your 401(k) fund to prior levels, and that means less money for your retirement.
  • If you leave your employer, you most likely will have to pay back the full loan amount within 90 days.
  • You could be charged major fees and tax penalties if you do not repay the loan.

Check out the IRS website for more information on 401(k) loans. As always, we’ve got your back.

— The OYO Team

[Any reference to a specific company, commercial product, process or service does not constitute or imply an endorsement or recommendation by On Your Own, the National Endowment for Financial Education or any of its affiliate programs.]