If you are thinking about taking out a loan against your 401k, you’re not alone. Before you pull the trigger though, it’s important to explore all of your options and know exactly what you’re getting into. In certain circumstances, it can be the right choice–but there’s a certain amount of risk involved.
Dependent on different factors–mainly the stock market, job security, and your credit score–a 401k loan may be the best choice for some, but because of the risk involved it’s important to take special note of all the terms and have a plan for repayment if you decide it’s the right choice for you.
In this guide, we’ll discuss the factors that could make taking out a 401k loan a good option as well as the advantages and disadvantages. From there, we will talk about alternatives to a 401k loan
Factors to consider
While initially borrowing from yourself (and paying yourself back with interest) can sound like a good idea, there have to be certain circumstances in place to make it worth the risk. Most important to take into consideration is the state of the stock market and if your investments have the potential to grow significantly, and also if you have job security (or risk facing costly consequences should you lose or leave your job for any reason).
One of the main arguments against taking out a 401k is that you’re missing out on potential growth. However, if the market is down or the country is experiencing a recession, this may not be as much of a blow as you think.
A dip in the market or a recession is when most people need a little extra money for one reason or another. However, this can also make taking out a 401k extra risky considering the next factor.
The other major argument against taking out a 401k loan is the consequences you could face if you were to leave (for any reason) or were let go of a job while you still have an outstanding balance.
Ultimately, it’s the plan administrator who decides when you repay the loan, although the IRS states that you have until taxes are due the upcoming year to either roll over the 401k to another 401k (or equivalent) plan, or to repay the loan in full.
If you are unable to pay, the IRS views this similarly to defaulting on the loan and participants must pay the 10% penalty for early withdrawal–if they are under 59 ½ years old. Taxes will be due at this time as well, making it very costly. To avoid this, you can rollover the loan to another 401k or qualifying plan before time is up.
What exactly is a 401k loan?
Taking out a loan on your 401k allows you to borrow money from yourself. You still have to pay back interest, but it goes back into your retirement fund. Depending on the circumstances, this may have little, neutral, or a positive effect on your savings for the future. In most cases, the interest you pay back to yourself ends up being less than the cost of paying real interest on a bank or consumer loan.
Why do people take out a 401k loan?
It isn’t all that uncommon for people to decide to take out a 401k loan. In fact, 13% of plan participants have an outstanding balance on their 401k from a loan.
People may take out a 401k loan for anything they deem necessary and may use the money from the loan for:
- Paying household bills and expenses
- Funding a down payment for a house
- Paying off high-interest debt
- Cover medical expenses
- Paying back taxes owed to the IRS
- Funding necessary home repairs or improvements
Any of these situations are perfectly good reasons to take out a loan, especially if it can help you get out of a financial situation that could cost you more in the long run should you not take care of it.
How much can you take out?
Employees may take out a loan for 50% of their vested (meaning they fully own the funds) account balance or $50,000, whichever is less.
Unless the balance is under $10,000, then participants may take out a loan for the full amount. Your plan administrator may have a minimum amount you can take out so be sure to check in with them if the amount you are looking to take out is under $10k.
When do you need to repay it?
The IRS guidelines state that loans must be repaid within five years, and repayments must be made at least quarterly–some plans may be different and require you to make payments monthly.
This repayment period may be extended if the participant is using the loan to purchase a primary residence. While it is not wise to finance the entirety of your home with a loan from your 401k (nor could you in most cases), it is a good option if you need a little extra money for the down payment.
Advantages to taking out a 401k loan
In the right circumstances, such as when there is a dip in the market, and as long as the intention is to take out the loan for the short-term and in a responsible manner, it may have little to no effect on your progress in saving for retirement.
Fast and easy way to get cash
One of the biggest advantages of taking out a 401k is that it is one of the quickest and easiest ways to get your hands on a lump sum of cash. For the most part, the money you take out can be used for anything you deem necessary–from paying off the last bit of student loans to a down payment for a home and anything in between (even household bills!).
Skip the credit check
With this type of loan, you generally won’t even need to go through a credit check since you are borrowing your own money. This makes a 401k loan an especially good option for those with a lower credit score that may prevent them from getting a good rate for a loan elsewhere.
Generally, when you take out a loan the IRS requires you to follow a five-year repayment plan, however, some 401k loans allow you to repay the loan off faster without a prepayment penalty. This allows you to put your money back in the fund as quickly as possible so you don’t miss out on any employer matching or potential gains your funds could make in the market.
Making the most of your 401k loan
The best advice to follow when taking out a 401k loan is to repay it as soon as possible to not only get back on track for saving for retirement but also avoid consequences in the case that you suddenly lose your job or decide you would like to leave. As touched on earlier, the consequences can be severe–not to mention costly–if you leave a job with an outstanding balance.
We’ve taken a look at the advantages of taking out a 401k loan. Now, it’s time to look at some of the shortcomings of taking out this type of loan.
Pauses potential growth
The money you take out cannot grow, and this can hurt you in more ways than one.
If you decide to take out a 401k loan, you’ll want to time it carefully–you don’t want to miss out on growth that funds could make in the market.
Another thing to note is that repayments do not count as contributions to the fund and thus if employer matching is dependent on employee participation, you could be missing out on free money to grow your nest egg.
To get a better understanding of all your options, make sure you consider the following alternative ways to secure the money you need.
An alternative to taking out a 401k loan is taking out a hardship withdrawal from your 401k. Essentially, instead of repaying back the money, you are permanently taking the funds out of the account.
A hardship withdrawal is defined by the IRS as:
- Out-of-pocket medical expenses
- Down payment or repairs on a primary residence
- College tuition and related educational expenses
- Threat of mortgage foreclosure or eviction
- Burial and funeral expenses
Please note that plan providers may have a different definition that may not include all of the above.
You may have to pay the 10% early withdrawal penalty, but you may qualify for an exception.
Home equity loan
Do you have equity in your home? If so, you may be able to tap into it to qualify for a loan. This option makes sense especially if you are planning to use the funds for home repairs or improvements. Not to mention the interest on this loan could be tax-deductible, which is not the case for 401k loans.
While no one likes the idea of paying interest or unnecessary fees to a bank or lender, if you have a good credit score you may be able to strike a deal for a personal loan with favorable terms.
Personal loans are a great alternative to a 401k as they offer the same freedom to use the funds for whatever you need and they are typically unsecured, so you don’t have to put up collateral to secure the loan.
401k loans offer a quick and easy solution if you need fast cash and don’t have great credit, but make sure you understand the terms and have a plan for repayment.
The best practice when taking out a loan from your 401k is to take it out when the investments you have in there won’t be growing much anyways due to outside circumstances, such as the global pandemic or inflation, it’s also recommended to put the money back in as quickly as possible so you don’t miss out on other benefits, like employer matching.
Even so, take a look at all your options and compare interest rates to make sure you are making the smartest decision for your financial future. After all, anytime you take out a 401k loan you risk losing the money altogether should you decide to leave your job.
If you have good credit, it’s highly recommended that you look into a personal loan. If you are a homeowner, consider a home equity loan for the repairs and improvements you have been putting off. If you need any guidance to figure out the next best step, talk with one of our financial advisors.