If you need money for unexpected expenses in a pinch, you might consider taking out your 401(k) loan as an option – if funds are not available elsewhere.
A 401(k) is an employer-sponsored savings plan that allows you to set aside pre-tax dollars (or after-tax dollars, if you have a Roth 401(k)) from your paycheck to fund your retirement years. While personal finance professionals don’t recommend looting your retirement plan for cash when you can avoid it, an important way to take advantage of your 401(k) plan is with a 401(k) loan.
What is a 401(k) loan?
A 401(k) loan allows you to borrow money you put into a retirement account to pay back yourself. Even if you lend yourself money, it’s still considered a regular loan, charging the interest you incur.
When you take out a loan from a 401(k) plan, you get the same terms and conditions as any other type of loan: a repayment plan based on the size of your loan and a set interest rate. Under the IRS, you have five years to repay the loan unless the funds are used to buy your primary home. In this case, you have more time to repay.
However, 401(k) loans have some key drawbacks. When you’re paying back your own money, a major downside is that you’re still drawing money from your retirement account, which is growing tax-free. The less money you have in your plan, the less money you will get over time. Even if you get your money back, it will take less time to fully grow.
Also, if you have a traditional 401(k) plan, you will use your after-tax income to repay the pre-tax funds in the account, so it will take more time (in terms of working hours) to repay the loan.
Risks of getting a 401(k) loan
Before you decide to borrow money from a 401(k), keep in mind that doing so has its downsides.
You may not receive anything. Your ability to get a 401(k) loan depends on your employer and the plans they have in place. A 2021 study by pension data firm BrightScope and the Investment Company Institute found that 78 percent of plans had outstanding loans, based on 2018 data. So you have to look elsewhere for the money.
You have limitations. You may not get the cash you need. The maximum loan amount is $50,000 or 50% of your vested benefit account balance, whichever is lower.
Older 401(k)s don’t count. If you’re planning to get a 401(k) from a company you no longer work for, you’re out of luck. If you don’t put this money into your current 401(k) plan, you can’t borrow it.
You can pay taxes and penalties for this. If you don’t pay your loan on time, the loan can turn into an expense, which means you’ll end up paying taxes and penalties.
When you leave your job, you have to pay it back faster. If you change jobs, quit your job, or are fired by your current employer, you must pay off your outstanding 401(k) balance within five years. Under the new tax law, in this case, 401(k) borrowers must repay by the due date of their federal income tax return.
For example, if you have a 401(k) loan balance and leave your employer in January 2022, you must repay the loan by April 15, 2023 to avoid default and any early payment tax penalties, according to The Retirement Company Plan. The old rule required a refund within 60 days.
The benefits of borrowing from a 401(k)
Borrowing into a 401(k) isn’t ideal, but it does have some advantages, especially compared to cashing out early.
Avoid taxes or penalties. With a loan, you can avoid paying the taxes and penalties associated with early withdrawals. Plus, the interest you pay on the loan goes back into your retirement account, albeit after taxes.
Avoid credit checks. 401(k) loans also do not require a credit check or show up as debt on your credit report. If you’re forced to default on your loan, you don’t have to worry about it affecting your credit score, as defaults aren’t reported to the credit bureaus.
When a 401(k) loan makes sense
Borrowing from your 401(k) should be rare, but it can be useful if you need a lot of cash in the short term. It should not be used for small or non-essential things.
A 401(k) loan is often a better financial option than other short-term financing options like payday loans or even personal loans. These other loan options often come with high interest rates, making them less attractive. Also, arranging a 401(k) loan is relatively easy compared to applying for a new loan from other financial institutions.
Can you pay off your 401(k) loan early?
Yes, loans from a 401(k) plan can be repaid early without paying a prepayment penalty. Many plans offer the ability to repay the loan through regular payroll deductions that can increase the time to repay the loan earlier than the five-year requirement. Remember, these payments are made in after-tax dollars, not pre-tax contributions.
Will your employer know if you apply for a 401(k) loan?
Yes, your employer will likely know about each loan from their own sponsorship program. You may have to apply for a loan through Human Resources (HR), which you will pay back through payroll deductions, and they know that. Additionally, there is no guarantee that points will be approved, or that your program may not offer points at all. If you are concerned that a manager or executive will find out about your loan application, you should ask Human Resources to keep your application confidential.
Early withdrawal is less attractive than credit
An alternative to a 401(k) loan is a hardship distribution as part of an early withdrawal, however, this is associated with various taxes and penalties. If you withdraw your funds before retirement age (59½), you will generally be subject to income tax on any bonuses and may be subject to a 10% bonus penalty depending on the nature of the hardship.
You can also claim hardship compensation if you withdraw your money early.
The IRS defines a hardship distribution as “the employee’s immediate and serious financial need,” adding that “the amount must be necessary to meet the financial need.” This type of early withdrawal does not require any repayments and does not incur any penalties.
Allocating difficulty by quitting early covers a number of different issues, including:
certain medical expenses
Some of the Costs of Buying a Principal Home
Tuition, Fees, and Education Expenses
Costs to prevent eviction or foreclosure
Funeral or funeral expenses
Emergency home repairs for uninsured accidental damage
Hardship may be relative and your hardship may not qualify for early withdrawal.
This type of withdrawal does not require any repayment. However, you should avoid early withdrawals as much as possible due to the severe negative impact on your superannuation. Here are some ways to avoid these high taxes and get your retirement on track.
Other Alternatives to 401(k) Loans
Borrowing from yourself may be an easy option, but it may not be your only option. Here are some other places where you can find money.
Use your savings. Your emergency cash or other savings can be critical right now – and why you need emergency savings in the first place. Always try to find the best interest rate on a high-yield savings account to get the most out of your money.
Take out a personal loan. Personal loan terms may make it easier for you to repay without hurting your retirement savings. Depending on your lender, you can get your money in a day or so. 401(k) loans may not be effective immediately.
Try HELOC. A Home Equity Line of Credit (HELOC) is a great option if you own your home and have enough equity to borrow. You can take out what you need when you need it, up to the limit you are allowed to use. As a revolving loan, it’s similar to a credit card – the cash is there when you need it.
Get a home equity loan. This type of loan can usually give you lower interest rates, but keep in mind that your home is being used as collateral. This is an installment loan, not a revolving loan like a HELOC, so it’s best to know exactly how much you need and what it will be used for. Make sure you can repay the loan as it is easier to get or risk the home defaulting.
If taking money out of retirement is your only option, a 401(k) loan may be right for you. However, before using this option, try to find other ways. Depending on your needs and when you need them, you may have other options that are better suited to your situation. Not having an emergency or retirement plan is America’s biggest financial regret.
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