401K Loan: Borrowing From Your Retirement
Borrowing from your 401k is rarely an ideal choice when in need of a loan. However, under certain circumstances, borrowing from your 401k may be the best choice. Read on for everything you need to know about borrowing from your retirement and taking out a 401k loan.
If you have been depositing money into a 401K retirement savings account since entering the workforce, you might have a sizable amount set aside for your retirement. While it is always best to leave that money invested and let it continue to grow, sometimes expenses come up, and you might not have the liquid funds to cover them.
Going into credit card debt or taking out a personal loan to cover your expenses are options that can cost you a lot in interest and fees. While withdrawing from your 401K early is generally not a good idea, taking out a 401K loan could be a good financial decision depending on your circumstances.
What Is a 401K Loan?
A 401K loan is money borrowed from your 401K account balance. The loan is tax-free, and because it is a “self loan” (you are borrowing from yourself), any interest on the loan goes into your 401K account.
How Does It Work
To take out a 401K loan, you will first need to apply for the loan through your plan sponsor. Once approved, you will sign a loan agreement detailing the principal, interest rate, fees, and loan term.
Some 401K loans will take a portion of money from each of your investments, while others allow you to choose which investments you pull funds from.
How Much You Can Borrow
You can borrow $50,000 or up to half the total vested amount in your account, whichever amount is lesser.
A person usually repays 401K loans through payroll deductions. These deductions are taken post-tax, unlike the pre-tax funds that initially built your 401K.
The standard repayment period is five years (the longest term the government allows), but you may be able to negotiate a shorter term. The exception is if you are taking out a 401K loan to buy a primary residence; in that case, many plans will let you borrow for up to 25 years. Monthly or quarterly payments are made until the 401 k loan is paid off.
The biggest risk with repaying your 401K loan is that you will probably be required to pay back the loan in full within 90 days if you lose your job. If you do not pay it back within that time, you will be in default, leaving you subject to income tax on the total amount and, if you are younger than 59 ½, a 10% penalty for early 401K withdrawal.
Like any loan, a 401K loan will incur some initial fees. You will need to pay an origination fee, which is usually between $50 and $100. You may also need to pay a maintenance fee of $25 to $50. Together these fees can cost up to $150.
If you do not pay your 401K loan back within the 5-year term, the IRS will consider it disbursement, and they will charge you an income tax and a 10% 401K early withdrawal penalty.
Why Borrow From Your 401K?
There are many reasons it might make sense to borrow money from your 401K instead of seeking other avenues for borrowing money. In general, taking money out of your retirement savings early is a bad idea. However, a 401k can be the best choice under certain circumstances.
It’s Quick and Convenient
A person can easily procure 401K loans. They generally do not require any sort of application or credit check and therefore do not negatively affect your credit score. In addition, many 401Ks allow you to request a loan easily on their website, with funds available to you within a few days.
Some companies have even implemented the use of debit cards, making your loans available instantly. As long as you follow all 401K withdrawal rules, you will avoid a penalty for withdrawing from the 401K early.
Although most 401K loans require a 5-year repayment period, you can pay off your loan early with no prepayment penalty. You can repay most 401K loans through convenient payroll deductions.
Although you do not have to pay many (if any) up-front fees to procure a 401K loan, the hidden cost is the loss of investment earnings.
When you take out a 401K loan, you can usually choose the investments that money is pulled from. Unfortunately, this means you will lose the earnings those investments would have incurred during the duration of your loan.
The cost advantage is the cost you would pay in interest on a consumer loan minus your lost investment earnings. For example, if a bank loan charges an interest rate of 8%, and your lost investment earnings are 3%, your cost advantage is 5%. (8%-3%=5%)
Calculate your cost advantage before taking out a loan. A 401K loan might be a good choice if the cost advantage is positive.
Can Benefit Retirement Savings
When you borrow money from your 401K, you might think your retirement savings will suffer. However, that is not necessarily true, and your retirement savings can benefit from you taking a 401K loan.
Any interest you pay on your loan goes back into your account. Because of this, you are paying back more than you initially took out of your 401K. If the interest is more than your lost investment earnings, your 401K will help your retirement savings grow.
Is a 401K Loan the Same as a 401K Hardship Withdrawal?
Under certain circumstances, you may qualify for a 401K withdrawal due to hardship. However, you will only be able to make hardship withdrawals if you have a qualifying financial emergency. The IRS has guidelines for what may qualify you for a hardship withdrawal, but each employer can set specific criteria for what counts.
Some expenses that may qualify for a 401k withdrawal include a down payment or repairs on your primary residence or the threat of foreclosure or eviction. Medical expenses, funeral and burial costs, and college tuition or other educational expenses may also qualify.
Unlike a 401K loan, you do not need to repay hardship withdrawal 401K funds. However, you will need to pay taxes on the funds and a 10% 401K withdrawal penalty if you are under 59 ½ years old. In addition, many employers will not let you deposit into your 401K for six months following a financial hardship withdrawal, according to the IRS.
401K Loan Pros
There are many reasons a 401K loan can be an attractive option when you need money. You usually don’t need to explain why you need the money or what you will use it for. In addition, you may qualify for a lower interest rate than you would at a bank, particularly if you have a low credit score on your credit report.
You pay interest back into your 401K account. Since you are borrowing instead of withdrawing, you won’t owe income taxes on 401K withdrawal.
401K Loan Cons
Although a 401K can often be a good option when you have a financial need, there are several reasons it might not be the best idea.
The money you withdraw will stagnate since you are not investing it. You will make repayments with after-tax dollars, which will be taxed again when you eventually withdraw money from your 401K.
Fees for this kind of loan may be higher than fees for a regular loan. Interest payments on a 401K loan is never deductible.
Is It Wise to Take a 401K Loan?
Depending on what other avenues are available to you, it may or may not be a good idea to take out a 401K loan. You want to avoid taking money out of your retirement account early. In many circumstances, a 401K loan should be a last resort.
Alternatives to a 401K Loan?
Before taking out a 401K loan, you should consider all alternatives. Many other options might help you avoid the potential consequences.
HSA Savings for Qualified Medical Expenses
If you need funds to cover medical expenses, you would probably be better off using your Health Savings Account (HSA). HSA dollars are untaxed, and you can use them to cover a wide range of medical expenses, including copayments, deductibles, and coinsurance.
Using Emergency Savings
If you have an emergency savings account, using those funds would likely be better than taking out a 401K loan. Withdrawing money from a savings account does present potential consequences of tax liability or penalties. This way, you also avoid any negative cost advantage.
Home Equity Line of Credit
If you are fine with using your house as collateral, a Home Equity Line of Credit (HELOC) can be a good option when faced with emergency costs. You can take out a line of credit that will be available to you at any time, similar to a credit card. An attractive aspect of a HELOC is that you will not accrue interest on untapped funds.
401K Loan FAQ
Before applying for a 401K loan, learn what to expect. Then, use an online 401K loan calculator to estimate the financial implications of your loan.
Is There a Limit on 401K Loans?
The maximum amount you can take out as a 401K loan is generally $50,000 or half of your vested account balance, whichever value is the lesser of the two, as discussed earlier. In addition, there is often a loan floor or a minimum amount you must borrow.
Most plans allow you to take out a second 401K loan while still paying back the first loan so long as the total outstanding amount does not exceed the loan limit.
Who Should Take Out a 401K Loan?
You should only take this type of loan if you are confident you will remain at your job until you have repaid your loan. A 401K loan might be the best choice for you if you want to make a down payment on a home, if you need to pay off high-interest debt or if you are in dire financial need.
Can You Pay Off a 401K Loan Early?
Although most 401K loans require a 5-year repayment period, you can pay off your loan early with no prepayment penalty.
Is a 401K Loan Considered Income?
A 401 K loan is not considered taxable income unless you default on the loan. If you do not pay the loan back within five years, it will be classified as a distribution, meaning the loan is taxable income.
Can You Get a 401K Loan With Bad Credit?
Yes. A 401k loan is advantageous to those with less than perfect credit because you are often able to get a lower interest rate. As stated above, even if you have bad credit, you don’t normally have to explain why you are borrowing the money.
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Borrowing from 401 K retirement funds is not an ideal scenario. However, sometimes a 401K loan might be the best option when you need extra cash. Research all available options and learn about all 401 K loan rules to avoid any 401K penalty fees.
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