Thinking about borrowing from your 401(k)? You’re not alone. Life throws all kinds of unexpected expenses your way, whether it’s a medical bill, home repair, or just trying to stay afloat during a tough patch. In moments like these, dipping into your retirement savings might seem like a practical option. Before you take that step, it’s important to understand how this type of loan works and what it means for your future finances. Let’s walk through it together so you can make a clear and confident decision.
What is a 401(k) Loan?
A 401(k) loan lets you borrow money from your own retirement savings. You’re basically taking a loan from yourself and then paying it back with interest. The interest you pay goes right back into your 401(k) account, which helps your retirement savings grow a bit more in the long run.
Most plans let you borrow up to 50% of your vested balance, with a maximum limit of $50,000. On average, people borrow around $10,778, and Gen Xers currently hold more than half of these loans. What makes this loan different is that you’re both the borrower and the lender. This setup makes it easier to qualify, but it also means you carry the full risk if you miss payments.
When to Think About Taking a 401(k) Loan
Many financial experts say it’s better to avoid borrowing from your retirement savings unless it’s really necessary. But there are times when a 401(k) loan can be the better option.
If you’re facing a financial emergency and can’t get a personal loan due to poor credit, a 401(k) loan might help you out. It can also be a safer choice compared to payday loans or early withdrawals, which often come with heavy penalties.
That said, only consider this option if you feel secure in your job. If you leave or lose your job while still repaying the loan, you may have to pay the full amount quickly. If not, the unpaid balance could count as a taxable early withdrawal.
How Do 401(k) Loans Work?
If you’re thinking about borrowing from your 401(k), it’s good to understand how it all works. Here’s a closer look at all the important parts.
- How Much You Can Borrow: As mentioned earlier, you can borrow up to 50% of your vested balance, with a cap of $50,000. “Vested” means the portion of your 401(k) you actually own. While the money you contribute is fully yours right away, the money your employer adds might take time to become yours based on their vesting schedule. If it’s not vested, it can’t be borrowed. Some plans also allow you to take more than one loan, as long as the total borrowed amount stays within the limit. So, if you already borrowed $10,000, the most you can borrow again would be $40,000.
- How You Repay the Loan: Most 401(k) loans need to be paid back within five years, as mentioned earlier. Payments are usually made regularly, either weekly, biweekly, or monthly, depending on what your plan allows. These payments need to be consistent over time.
- Interest on the Loan: Your 401(k) loan will have interest, just like any other loan. There’s no fixed rate, but most plans charge interest similar to the prime rate. However, what’s interesting about 401(k) loans is that you’re paying interest back into your own account. So, while you still owe more than what you borrowed, that extra amount goes back to grow your retirement savings. And since 401(k) loans often have lower interest than personal loans, you might save money too.
- If You Leave Your Job: If you leave your job before repaying your loan, things can change quickly. In many cases, you’ll need to pay off the remaining balance right away. It doesn’t matter if you quit or got laid off, the loan becomes due the moment your job ends.
- What Happens If You Don’t Pay It Back: If you don’t repay your loan on time, the unpaid part becomes an early distribution. That means it’s treated like you took the money out of your retirement early. You’ll pay regular income tax on that amount. If you’re under 59, there’s usually a 10% penalty added too.
Top 4 Reasons People Borrow from Their 401(k)
- It’s Fast and Private: Taking out a 401(k) loan is usually much easier than applying for a regular loan. There’s no credit check, no long forms, and it doesn’t show up on your credit report. Many plans let you apply online, and you can get the money in just a few days. Some plans even offer a debit card that lets you borrow smaller amounts instantly.
- Flexible Repayment Options: While the general rule says you have five years to pay it back, you can always repay it sooner. Most plans let you repay the loan through payroll deductions, which makes it easy to stay on track. You’ll see your payments and remaining balance clearly on your plan statement, just like with a regular loan.
- Lower Cost Compared to Other Loans: There’s usually no major fee to borrow from your 401(k), just a small admin or setup charge. The money comes out of your investments, which means you won’t earn anything on it during that time. But on the flip side, you also avoid any losses if the market goes down. Here’s a simple way to look at the cost benefit:
Let’s say a personal loan charges you 8% interest, and your 401(k) is earning 5%. If you borrow from your 401(k), the “cost” of the loan is just the 3% difference. If the numbers work in your favor, borrowing from your plan can actually be cheaper than other options.
- It Might Even Help Your Retirement: As you repay the loan, the money goes back into your investments. You’re paying back a little more than you borrowed, and that extra amount is interest going straight into your account. If that interest makes up for what you missed in market gains, then your overall retirement savings stay on track. In some cases, you might even come out ahead, though this usually means you’re taking a hit on your personal savings outside the retirement account.
Opportunity cost of borrowing from your 401(k)
The amount of interest that you would pay on the loan has to be legitimate and commensurate with other loans.
How To Take a 401 (k) Loan Penalty & Tax Free With The CARES ACT
Repaying a 401(k) loan
If you’ve taken a loan from your 401(k), you usually get up to five years to pay it back. But if you miss the deadline, things can get expensive. You’ll end up paying regular income tax on the unpaid balance and maybe even an early withdrawal penalty if you’re under 59½.
To avoid that, it helps to have a plan. Look at your finances and figure out how quickly you can repay the loan. Decide how often you’ll make payments. It can be weekly, biweekly, monthly, or quarterly as per what suits you.
A good repayment plan should do two things. First, it should help you clear your loan within the given time or even earlier. Second, it should still leave room for you to continue contributing to your 401(k) regularly.
Also, think about what would happen if you leave your job or lose it. Most 401(k) loans need to be paid back quickly if you’re no longer employed. Do you have enough savings to handle that? If not, you might be forced to take an early withdrawal, which could cost you more in the long run. Even if you’re not planning to leave, it’s better to be prepared.
Alternatives to 401(k) Loans
Sometimes borrowing from your 401(k) isn’t your only option. Here are some other choices that might suit you better.
- Personal Loans: Personal loans are unsecured, which means you don’t have to offer anything as collateral. You can use them for emergencies to big purchases, just about anything. The interest rates are fixed, and you’ll pay the same amount every month.
The amount you can borrow depends on your credit score. Some lenders offer loans up to ₹80 lakhs with repayment terms of up to seven years. Interest rates are usually higher than 401(k) loans but lower than most credit cards. Many people use personal loans for things like consolidating debt or covering urgent expenses.
- Home Equity Loans and HELOCs: If you own a home, you might be able to borrow against its value. A home equity loan gives you a lump sum with a fixed interest rate, while a home equity line of credit (HELOC) works more like a credit card that you can draw from as needed.
These options usually come with lower interest rates because your home acts as collateral. But be cautious. If you fail to repay, your home could be at risk. Lenders typically let you borrow up to 80 percent of your home’s value, minus what you still owe on your mortgage.
- 0% APR Balance Transfer Credit Cards: If your goal is to pay off credit card debt, a balance transfer card might help. Some credit cards offer 0% interest on transferred balances for a limited time which is usually between six months to two years. If you can repay the full amount during this time, you’ll avoid paying any interest.
Keep in mind that you need good credit to qualify. Also, once the 0% period ends, the interest can shoot up. Many cards also charge a small transfer fee, so always read the fine print before applying.
- Emergency Fund: If you haven’t built an emergency fund yet, now is the time to start. Ideally, you should have three to six months’ worth of expenses set aside for unexpected situations. An emergency fund gives you the freedom to handle surprises without needing to take out a loan.
If you already have some savings, consider using that instead of borrowing from your 401(k). It’s a safer move and keeps your retirement plan on track.
Pros of a 401(k) Loan
- Lower Cost than Most Other Loans: A 401(k) loan can be cheaper than borrowing through personal loans or credit cards. The interest rate is usually lower, and the best part is that the interest you pay goes back into your own retirement account instead of someone else’s pocket.
- No Effect on Your Credit Score: You don’t need approval from a bank or lender to get a 401(k) loan. Since there’s no credit check involved, your credit score stays untouched and the loan won’t show up on your credit report.
- No Early Withdrawal Taxes or Penalties: As long as you repay the loan on time, you can avoid the taxes and penalties that usually come with pulling money out of your 401(k) early. This gives you access to your savings without the usual IRS consequences.
- Easy repayment process: Repaying a 401(k) loan is often simple because payments are deducted straight from your paycheck. Many plans also allow you to pay it off early without any extra charges or penalties.
Cons of a 401(k) Loan
- Cuts Into Your Retirement Savings: Borrowing from your 401(k) means pulling money out of an account that is supposed to grow over time. Even if you repay it, you miss out on potential investment gains during the time your money is not in the market.
- Might Need to Repay Faster if You Leave Your Job: If you switch jobs or get laid off, you may need to repay the full loan much sooner than expected. Some plans give you as little as two or three months. This can cause financial stress, especially if you’re not prepared.
- Can Trigger Taxes and Penalties if you Default: If you’re unable to pay back the loan, the IRS will treat the unpaid balance as a withdrawal. This means you could owe taxes on it. And if you’re under 59 and a half, you’ll also get hit with a 10 percent penalty.
- No Protection in Bankruptcy: If you file for bankruptcy, you’re still responsible for paying back your 401(k) loan. Unlike other debts that may be forgiven, this one sticks around no matter what.
Closing Thoughts
Taking out a 401(k) loan gives you short-term access to your retirement savings, which can help when you’re dealing with urgent financial needs. Like any loan, it comes with both pros and cons.
If you’re thinking about going this route, take a moment to look at other options first. There might be something else that suits your situation better. But if you decide that a 401(k) loan is the right move, make sure you fully understand the terms. Have a clear plan to pay it back as soon as you can so your retirement savings stay on track.
Need help navigating 401(k) loans? Let our experts assist you.
FAQs
What is the 12-month rule for 401(k) loans?
Depending on your plan, you might be allowed to take out more than one 401(k) loan at the same time. But during any 12-month period, the total amount you owe across all loans can’t go over 50% of your vested account balance or $50,000, whichever is lower. It’s always a good idea to check the details with your plan provider before borrowing.
Should I borrow from my 401(k) to pay off credit card debt?
Only consider this if you have no better options. Paying off high-interest credit card debt might feel like a win, but dipping into your retirement savings can hurt you later. Weigh the costs carefully.
How long do you have to pay back a 401(k) loan?
Most plans give you up to five years to repay the loan. If you’re using it to buy a home, you may get more time.
Does my employer have to approve my 401(k) loan?
Yes. Your employer or plan administrator needs to approve the loan. They’ll also set the repayment terms and conditions.
Is it better to take a loan or withdrawal from a 401(k)?
A loan is usually better than a withdrawal because it lets you pay the money back. A withdrawal is permanent and may come with taxes and penalties. Always try to protect your retirement savings if possible.
Can I take out multiple loans from my 401(k)?
No, typically, you can only have one outstanding loan at a time from your 401(k) plan.
What happens if I leave my job with an outstanding 401(k) loan?
If you leave your job with an outstanding 401(k) loan, you’ll usually need to repay the loan in full within a specified timeframe, often within 60 to 90 days, to avoid taxes and penalties.
Are there any restrictions on how I can use the funds from a 401(k) loan?
While there are no restrictions on how you can use the money, it’s important to consider the long-term implications on your retirement savings.
Do 401(k) loans affect my credit score?
No, since they’re not reported to credit bureaus, they don’t impact your credit score.
What happens if I can’t repay my 401(k) loan?
If you’re unable to repay the loan, it’s treated as a distribution, subject to taxes and penalties, and may derail your retirement plans.
