I’m going to get this out of the way at the top: I don’t like to encourage 401(k) loans. I strongly believe that taking a 401(k) loan puts people in a hole they may not recover from which can severely limit their retirement savings. However in some instances, even with the consequences, taking a 401(k) loan may be the best route for certain individuals.
Note: while I’ll be referencing 401(k) loans, other retirement plans – such as 403(b)s – offer the same type of loan.
What is a 401(k) loan?
A 401(k) loan is a way to borrow money from your retirement savings account. You may generally borrow up to 50% of your vested account balance or $50,000, whichever is less. You must repay the loan within five years (you may have a longer repayment period if the loan is used for a home purchase) through quarterly payments. Not all retirement plans allow loans; check with your HR department or read through your Summary Plan Description to learn more.
What are some advantages of taking a 401(k) loan?
401(k) loans can provide some benefits when compared to other types of loans or withdrawals.
No credit check. There is no credit check or lengthy application process. 401(k) loans are typically quick and easy to obtain since you’re borrowing from your own retirement account.
Interest. Normally, you will receive a lower interest rate on 401(k) loans compared to personal loans or credit card rates. And the interest you pay goes back to you – you repay the loan into your own 401(k) account, not to a bank or other lender.
Avoid taxes and penalties. If you choose to simply close your 401(k) account, you will lose a large portion of it to taxes and penalties if you’re under age 59½. Taking a loan means you won’t have to pay the 10% penalty and taxes on your withdrawal as long as you pay off the loan.
What are some disadvantages of taking a 401(k) loan?
Job loss. If you leave your job or are terminated, you may be required to repay the entire loan balance quickly, often within 60 days or by the due date of your federal income tax return. Failure to do so can result in the loan being treated as a taxable distribution.
Reduced retirement savings. Borrowing from your 401(k) reduces the amount invested for retirement, potentially impacting long-term growth and compounding returns. While your borrowed money is out of your account, you miss out on potential gains.
Additionally, many people who need a loan are no longer able to make regular contributions – or must reduce their contributions – to their retirement plan. This only makes saving for a comfortable retirement more difficult.
Double taxation. One of the advantages of a traditional retirement plan is your contributions are pre-tax. You lose this tax advantage on the loaned amount since you repay the loan with after-tax dollars. And it will be double taxed, because you’ll pay taxes again when you withdraw the money in retirement.
Credit score. While taking a normal loan would give you a chance to improve your credit score (through on-time payments), this loan is not reported to the credit unions so there’s no opportunity to boost your score.
Fees and penalties. Some plans charge loan origination fees, maintenance fees, and other fees/penalties if you fail to repay the loan in full. Make sure you understand all fees before deciding on a 401(k) loan.
Alternatives to a 401(k) loan
You should consider a 401(k) loan only after you have investigated other options.
Personal or home equity loan. If you have good credit, a personal loan can provide quick funds with lower rates than a credit card. And if you’re a homeowner, you may borrow from the equity in your home.
Adjusting your contributions. Instead of taking money out of your account, consider temporarily lowering or stopping your contributions instead to free up monthly cash flow.
Roth IRA. Many people may not know this, but contributions to a Roth IRA can be withdrawn at any time with no penalty since they were after-tax contributions. Note that earnings cannot be withdrawn penalty-free, only your contributions.
Household spending. Before taking any loan, look closely at your budget to see if there are immediate cuts you can make. Also consider ways to increase your income, including selling personal assets or adding a part-time job.
Whatever you decide, make sure you fully understand the terms and conditions of any loan before you apply. If you are considering a loan from your retirement plan, also think about your job security and your desire to remain in the job. Having 60 days to repay $50,000 isn’t something anyone wants to deal with.
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