Anyone who’s experienced financial need can relate to the temptation. You’ve methodically funded your company-sponsored 401(k) retirement plan year after year, never expecting to withdraw a dime until you kissed the job goodbye and retired.
Then life got in the way.
Medical bills, growing credit card debt or even the desire to start a business or buy a house require more cash than you’ve stashed in your savings accounts. One of your colleagues mentions that she borrowed from her 401(k) a couple years ago for an emergency and it made all the difference. Suddenly, you want to know more.
If you are participating in your company’s 401(k) plan, the first move is to contact payroll or human resources department to see if your 401(k) plan permits loans. If it does, and most do, the process is quite easy, though there are often conditions so get all the information available before deciding what to do.
Since 401(k) borrowing is lending to yourself, you won’t face the financial vetting that outside lenders would normally put you through. You don’t have to provide income statements or undergo a credit check.
You must pay back the loan within five years, but you can apply future 401(k) payroll contributions to the balance due. You also must pay interest on the loan, which your fund administrator will calculate, but the interest is money you pay yourself, not to your company or the fund manager. Typically, the interest rate is the current prime rate with a percentage point or two added on.The human resources department will tell you how much money you have available to borrow and the conditions for repaying the loan. They should prepare the paperwork and all you have to do is sign the agreement and abide by those conditions.
What Is a 401(k) Loan?
The 401(k), introduced in 1978 under federal law, was designed to help employees save for retirement at a time when conventional pensions were starting to disappear. Today, the 401(k) and the individual retirement account (IRA) are core wealth-building tools. Since the retirement accounts are for retirement, using the money ahead of time is discouraged and is usually penalized. But the federal law created an option that gives 401(k) savers access to their money to cover pre-retirement needs.
Money borrowed from a 401(k) is a loan to yourself – with strings. If you don’t follow the repayment rules, you could face a hefty tax penalty. Even if you follow the rules, borrowing from a plan can result in a big setback to reaching your retirement savings goal.
But if you have a great need for money and no other way to reasonably borrow it, a 401(k) loan might make sense.
401(k) Loan Terms
What you can borrow from your plan has limits. Before you decide to use your 401(k) funds, you need to become familiar with how your plan is structured. All plans have borrowing limits, but some are more restrictive than others.
How Much Can I Borrow from My 401(k)
The maximum anyone can borrow is $50,000. Even if you have a $1 million in your account, $50,000 is the most you can borrow under federal guidelines. If you have less than $100,000 in your account, you only can borrow as much as half your balance – so if you have $84,000 in your account, you can borrow no more than $42,000. Some plans offer an option that allows you to borrow as much as $10,000 even if your account has less than $20,000 vested. Again, you need to read your plan’s rules or talk to your employer or plan administrator to learn more.
Repaying a 401(k) Loan
Borrowers repay their loans with payroll deductions. Unlike the money that funded the 401(k) originally, the repayment money is taxed and so is the interest required on the loan. This creates double taxation, at least on the interest portion of your payment. You will end up paying taxes twice on the interest, first when you pay it into the 401(k) and again when you ultimately withdraw from your 401(k) as part of your retirement.
This is one reason why you should only borrow from a 401(k) when it is the only viable alternative for meeting a financial obligation. 401(k)s were created to help you save for retirement, not pay bills while you’re working. By borrowing, you lose the tax-free growth that you might have had on your balance and you wind up paying taxes on both the money you repay the account and the interest.
If you fail to repay your loan within five years, the IRS likely will impose a 10% early withdrawal penalty on the balance due.
What Happens When You Leave Your Job?
A key borrowing risk is losing your job, or leaving it, before you’ve paid back your loan. The IRS requires that you repay the loan or face a 10% early withdrawal penalty if you are younger than 59 1/2. Though the tax law that took effect in 2018 gives borrowers more time to pay back a loan after leaving a job, the law still requires fast action. If you took a loan assuming you would repay it over five years and left your job the next month, you would have months, not years, to return the money to your account or face a penalty.
Loan Repayment After Leaving a Job
Under current tax law, you have until you file taxes the year after leaving your job to repay the loan. Unless you are older than 59 ½, failure to pay the balance incurs a 10% penalty on the balance. Since IRS rules allow a six-month extension on filing, that effectively means you have until October of the following year to return the balance with interest.
You can apply the amount due to your old 401(k) or a new one that you might set up with a subsequent employer. You can also deposit the money in your IRA to avoid a penalty.
Loan Repayment after Termination
The IRS doesn’t care if you quit your job, were laid off or were fired. The same rules apply in all cases – you either come up with the money to pay back the loan by October of the year following your departure from work or face an early withdrawal tax hit. The one exception are people older than 59 ½ and are no longer subject to early withdrawal rules.
Alternatives to a 401(k) loan
Although 401(k) borrowing has some advantages, including not having to jump through hoops for a commercial loan or undergoing a check of your credit score, there are downsides that discourage many would-be borrowers from using their retirement money in the present. Here are a few:
- Tax penalty for not repaying the loan on schedule.
- Loss of growth. 401(k) money could be invested in a mutual fund and grow tax free for many years until you retire. Money borrowed doesn’t grow, and the loss of compounding growth can make a big difference in your older years.
- You could get in the habit of using your 401(k) as a piggy bank, defeating its value as a savings tool.
- While you are paying back what you borrowed, you might not have the money to add to your account, further reducing its future value.
- 401(k) accounts are protected in bankruptcy. If you borrow money to help pay off a big debt and then discover that you still can’t avoid bankruptcy, you will lose whatever you withdrew. Not touching the 401(k) safeguards the money for your retirement.
After considering the drawbacks, many would-be 401(k) borrowers decide to look elsewhere for the money they need. Here are a few options:
Interest rates for borrowing against the equity in your house tend to be lower than most other loans, and the interest portion of payments is tax-deductible.
If you have credit card debt, consider debt consolidation through either a loan or balance transfer credit card. You could speed your repayment period by stopping 401(k) deductions from your paycheck while you’re paying off the consolidated debt.
The best way out of a financial mess is to have a plan. Nonprofit credit counselors like InCharge are excellent resources, and through free credit counseling, they will help you evaluate your debt and create a strategy for paying the money you owe.
Debt Management Plan
Credit counselors can create and manage a debt management plan to pay off your debts via a monthly payment to the counseling agency. The counseling agency will in turn distribute the payments to your creditors until the debts are paid off, usually within 3-5 years.
Ebeling, A. (2018, January 16) Need a 401(k) Loan? It Just Got Less Dangerous. Retrieved from: https://www.forbes.com/sites/ashleaebeling/2018/01/16/new-tax-law-liberalizes-401k-loan-repayment-rules/#966506b40f73
Mercado, D. (2019, August 22) Thinking of Borrowing from Your 401(k) Plan? Here’s What You Need to Know. Retrieved from: https://www.cnbc.com/2019/08/22/thinking-of-borrowing-from-your-401k-heres-what-you-need-to-know.html
Zinn. D. (2019, May 23) The Pros and Cons of Taking out a 401(k) Loan. Retrieved from: https://www.bankrate.com/loans/4-reasons-to-take-out-a-401k-loan/
Brandon, E. (2108, March 12) New 401(k) Loan Rules Make Borrowing Slightly Less Risky. Retrieved from: https://money.usnews.com/money/retirement/401ks/articles/2018-03-12/new-401-k-loan-rules-make-borrowing-slightly-less-risky
NA, ND. 401(k) Loan Withdrawals: Limits, Conditions & Considerations. Retrieved from: https://www.mortgagecalculator.org/helpful-advice/borrowing-from-your-401k.php
Akin, J. (2019, April 10) How to Borrow Money from Your 401(k). Retrieved from: https://www.experian.com/blogs/ask-experian/how-to-borrow-money-from-your-401k/
Dennis, M. (2017, August 3) When Is It OK to Borrow Against Your 401(k). Retrieved from: https://www.forbes.com/sites/financialfinesse/2017/08/03/when-is-it-okay-to-borrow-against-your-401k/#3fc5f0eb4757