401(k) Loans: How Do They Work?
If you need money for a significant expense but don’t want to take out a personal loan or another line of credit, you could consider borrowing money from your 401(k) retirement savings. Here’s a primer on how 401(k) loans work and the pros and cons to consider before deciding if it’s right for you.
Key Takeaways:
- A 401(k) loan allows you to borrow money from your retirement account without taxes, penalties or a credit check.
- You typically pay a lower interest rate for a 401(k) loan than other loans, and the interest you pay goes back into your retirement account.
- Borrowing cash from your 401(k) can limit how much your money can grow while it’s in your retirement account.
What Is A 401(k) Loan?
Many employers offer their employees the benefit of a 401(k) retirement savings account, so named because of the section of the federal tax law that allows it.
Employees who enroll can contribute a percentage of their pretax income to a 401(k) account, with the employer often matching a percentage of the contribution. The contributions are invested primarily in stocks and bonds, and the account owner can draw on their accumulated savings and investment profits when they reach retirement age.
While you can withdraw cash from your 401(k) savings, you must pay taxes and a 10% penalty on the amount you take out if you’re under 59 1/2 years old.
An alternative is to borrow cash from your 401(k) account and repay it to the account with interest. Essentially, you’re borrowing money and paying interest to yourself instead of to a third-party lender. You can avoid a credit check that could reduce your credit score and usually will pay a lower interest rate than you would with a personal loan.
That said, your plan may limit how much you can borrow and require your balance to be vested in a specific amount.
“To borrow against your 401(k), you typically need at least $2,000 in a vested balance – although the threshold can be lower, if your plan allows,” says Erika Kullberg, an attorney and personal finance expert.
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How Does A 401(k) Loan Work?
While details vary by plan, you can expect most 401(k) loan programs to follow these guidelines.
Borrowing Limits
Depending on your employer, you can take out as much as 50% of your savings, up to $50,000, over 12 months. However, your retirement plan may also have additional limits set by your employer.
Repayment
Most 401(k) loans require you to pay back the amount you borrowed – with interest – within five years.
“Repayment is typically made through payroll deduction, and there could be an administrative fee associated with the loan origination,” Kullberg says.
Your 401(k) plan may require you to repay a loan in full when you leave the company. If you cannot repay the loan, the loan balance becomes a withdrawal subject to taxes and penalties.
Interest Rates
401(k) loans come with lower interest rates than other loans – like a personal loan. This means you’ll be paying less for the loan overall and paying it back to yourself.
“In terms of interest, the rate is prime plus 1 to 2%, and the interest you pay is reinvested into your 401(k) plan,” Kullberg says.
Unpaid Loan Balances
If you cannot pay off your 401(k) on time, the remaining balance will be considered an early withdrawal. This means you’ll pay taxes on that money and a 10% penalty.
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Pros And Cons Of 401(k) Loans
Before you take out a 401(k) loan, it’s important to know the benefits and downsides. Here’s a look at some of the trade-offs to consider.
Pros
Some of the advantages of taking out a 401(k) include:
- Lower interest rates. 401(k) loans usually have lower interest rates than other loans. Not only will you be paying less interest, but the interest you pay goes back into your account.
- Avoid taxes and penalties. You won’t have to pay the taxes and penalties that you would with a 401(k) withdrawal.
- Easy to access. “A 401(k) loan can be easier – and often quicker – to obtain than a loan from a bank or other lender,” Kullberg says.
- Convenient repayment. 401(k) loan payments are often directly deducted from your paycheck.
- No credit check is needed. Because you won’t be working with a lender, a hard credit check isn’t necessary when taking out a 401(k). This means your credit won’t be affected.
- Defaulting won’t damage your credit. If you default on your 401(k) loan, it won’t hurt your credit.
- No prepayment penalties. If you can pay off your 401(k) loan ahead of schedule, you typically won’t have to pay a prepayment penalty.
Cons
It’s essential to be aware of the following potential downsides of taking out a 401(k) loan:
- Reduces retirement savings. “Money borrowed against your retirement account isn’t invested, so you’re giving up the opportunity for it to grow,” Kullberg says.
- Repaid with after-tax dollars. “Loan payments are made with after-tax money, so you’ll be taxed twice – once when contributing to the account, and once again when you withdraw the funds at retirement – after having been taxed every time the money was trading in the market,” Kullberg says.
- Penalties for default. If you default on your 401(k) loan, the remaining amount due is considered taxable income. You’ll also have to pay the 10% withdrawal fee.
- No bankruptcy protection. Even if you declare bankruptcy, you’ll still have to repay the balance on your loan.
- You may need to repay the loan in full if you leave your job. If you leave for a new job or are laid off, you may have to repay the loan balance immediately or pay taxes and penalties.
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How To Take Out A 401(k) Loan In 6 Steps
If you think a 401(k) loan might be right for you, here are some steps you can take to get one:
1. Ask If Your Employer Offers 401(k) Loans
Some employers don’t allow 401(k) loans. Ask your company’s benefits representative if 401(k) loans are available.
2. Learn The Terms
Some employers limit how much you can borrow. Your employer’s plan also sets the interest rate you’re charged and establishes the repayment schedule you’ll need to follow.
3. Request The Loan
The 401(k) loan application process is relatively simple and can typically be completed online.
4. Receive The Funds
Once approved, you’ll receive the money from your 401(k) plan administrator either through direct deposit or check.
5. Repay The Loan
There will typically be an option to deduct your loan payment from your paycheck.
6. Continue Making Contributions
It might be tempting to pause your 401(k) contributions while you repay the loan, but this can further hinder the growth of your long-term savings. Some plans will not allow you to contribute to your 401(k) account while repaying a loan.
4 Alternatives To A 401(k) Loan
If a 401(k) loan isn’t right for you, there are other options.
1. Emergency Savings
You can dip into your emergency savings if you need to cover an unexpected expense. This way, you’ll avoid borrowing money and paying interest. Just make sure that you don’t deplete your emergency fund too much in case something else happens.
2. Credit Card Balance Transfer
With a credit card balance transfer, you can transfer debt from a high-interest card to another offering low or no interest for a limited time. This gives you a window to quickly repay the debt without running up interest charges.
3. Home Equity Loan Or HELOC
If you own a home, you could take out a home equity loan or line of credit. Using your home equity as collateral can help you get better loan terms, but you could lose your house if you default.
4. Personal Loan
Personal loans come with higher interest rates than 401(k) loans, but they won’t affect your retirement savings.
FAQ
Here are answers to some common questions about 401(k) loans.
“Compared with a 401(k) loan, a personal loan also doesn’t affect your retirement savings and often offers a fixed interest rate and term, helping you to build credit if you make payments on time,” Kullberg says. “On the other hand, they usually require a credit check and often come with interest rates higher than 401(k) loans, with interest paid to a lender instead of to you.”
The Bottom Line
If you’re cash-strapped, facing an unexpected expense, or looking to make a wise investment, a 401(k) loan can help you borrow money and save on interest. If you’re younger and could use that money now to pay off high-interest debt, a 401(k) loan can be a smart move – especially compared to the taxes and penalties that come with an early 401(k) withdrawal. Just be sure to understand how taking that money out may limit your retirement savings potential.
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