Is A 401(k) Loan The Right Move?

A 401(k) is a retirement savings plan that many people rely on for their future. However, there may come a time when a 401k loan seems like a necessary option. This article explores the pros, cons, and considerations when borrowing from a 401(k) to help you make an informed decision.

The decision to take out a loan is a big one. While it can be tempting to tap into your 401k via plan loans, remember that the effect on your retirement savings can be much more significant than you think. Proceed with caution.

What is a 401(k) Loan?

A 401(k) loan allows you to borrow money from your 401(k) plan. While common in many retirement plans, companies are not required to offer loans. In addition, they can place restrictions on how much you can borrow and the reasons for the loan.

When a 401k plan allows this option, employees are often able to borrow up to 50% of their vested account value up to a maximum of $50,000, whichever is less.

Key Features

Interest rates

What you pay in interest is consistent with what you would find at banking or lending institution. Typically, rates will be in 1% to 2% over the prime rate. As of this writing, the prime rate is about 7.5%. 401(k) loans generally come with lower interest rates than traditional loans because they are secured by your retirement savings.

Repayment

Loan repayment occurs via payroll deduction with after-tax dollars. With each paycheck a portion will be allocated to your loan. This convenience minimizes the risk of missed payments or default. However, it also reduces your take-home pay, which may require adjustments to your monthly budget.

The Pros of Borrowing from A 401(k)

No Credit Check Required

A 401(k) loan is one of the few times you won’t need to worry about your credit rating. You can’t be turned down due to a credit check. Unlike traditional loans, a 401(k) loan does not require a credit check because you’re borrowing from your own funds.

This makes it an appealing option for individuals with low credit scores who may struggle to secure affordable loans from other sources. Additionally, it won’t affect your credit score.

Quick Access To Funds

No one likes crawling to the bank on their hands and knees. Fortunately, there’s no underwriting to determine your ability to pay it back. One of the significant advantages of a 401(k) loan is the speed at which you can access the money.

Unlike traditional loans that may require lengthy approval processes, 401(k) loans are often processed quickly, giving you access to funds within a few days. This can be especially helpful in emergencies.

Paying Yourself Interest

When you take out a 401(k) loan, the interest you pay goes right back to you. Since you’re lending yourself money, the interest is paid to you, not the company. This unique feature can make the loan feel less burdensome, as you’re essentially reinvesting in your own future while addressing current financial needs.

The Cons of Borrowing From A 401(k)

Opportunity Cost: Lost Investment Growth

When you withdraw money from your 401(k), the borrowed amount is no longer invested in the market. This means you miss out on potential gains, which can significantly impact your retirement savings over time. The longer the loan term, the greater the opportunity cost of lost compound growth.

Taxes & Penalties Due To Changes In Employment

If you quit or lose your job while you have an outstanding loan the loan is immediately due. Most of the time there aren’t funds available to pay the balance. If this occurs, the balance is treated as distribution and becomes taxable as income. If you’re under 59 ½ there will likely be early distribution penalties as well.

Impact on Retirement Contributions

Borrowing from your 401(k) can limit the amount you contribute to your retirement plan. There is only so much room in a budget. If you’re allocating part of your income to loan repayments, that means fewer dollars available for investment.

Considerations

401k Loan Costs and Fees

There are often loan processing fees involved with 401k loans. The plan administrator may charge a fee to set up the loan and can even charge quarterly or annual maintenance fees.

You will need to sell investments in your 401k account to fund the loan. This could result in short-term redemption fees if recently purchased or other transaction fees often buried in the prospectus. These fees add up and significantly add to the real cost of taking a loan.

Don’t underestimate how significant fees can be. When you are faced with a decision to pull money out via a 401k loan, it is likely that fees are not high on the list of concerns. But they should be. This is especially the case if you will be taking multiple loans.

I have personally seen many situations where as soon as one 401k loan is paid off, another loan is taken. This cycle repeats itself over and over. Don’t fall into this trap.

Diminished Retirement Savings

When you borrow from a 401k, you pay yourself back with interest. Sounds great, right? The reality is that this money has been removed from long term investments that grow tax deferred. Now you have a loan payment back to the 401k and it will likely crimp your budget. The most likely place to cut back will be your pre-tax salary deferral contributions.

That’s right. When you pay back the 401k loan, your loan payments are AFTER-TAX. Unless you’re able to continue the pre-tax salary deferral contributions you were making prior to the loan, you have dealt yourself a serious financial blow. You’ve likely lost the tax savings and traded them for after-tax contributions to pay back the loan.

Don’t be fooled by the “paying yourself back with interest” rational. It’s a bad deal. When you have money invested in your 401k your total return is comprised of reinvested dividends and increases in the share price over time.

When funds are pulled out via a 401k loan, not only are they potentially missing out on rising share values, but you’re no longer receiving the dividends. Real wealth is built over time so the key is to remain invested.

Taxes & Penalties Can Cost You

If you terminate employment, your outstanding loan balance will be deemed a distribution if not fully repaid. This means whatever balance is outstanding will become fully taxable at your income tax rate and if under age 59 1/2 additional early withdrawal penalties can apply. This could result in paying over 1/3 of the loan balance to the IRS come tax time.

Can I Borrow From An IRA?

One of the most common questions I get is if you can borrow from an IRA. The short answer is no. You can take withdrawals from your IRA at any time, but there is a catch. Assuming all the contributions you made were tax deductible, the withdrawals would be taxable as ordinary income.

If you are under age 59 ½, you would likely be subject to an early withdrawal penalty from the IRS. When added together, the taxes and penalties can take a huge bite out of your IRA.

There are exceptions to the early withdrawal penalties. I wrote an article called Avoiding The IRA Early Withdrawal Penalty which goes into more detail on this subject. There is also a way the IRS allows you to take substantially equal periodic payments which can qualify as an exception to the early withdrawal rules.

Just because you can take money out of an IRA, doesn’t mean you should. For many people, it is an easy place to look when funds are needed. It’s almost too easy to withdraw from an IRA and it can lead to less than optimal financial decisions.

Alternatives To Taking A 401(k) Loan

Personal Loans or Lines of Credit

Personal loans are unsecured loans offered by banks, credit unions, or online lenders that can be used for various purposes, such as consolidating debt, covering medical expenses, or financing a major purchase.

Since they are unsecured, they typically come with higher interest rates compared to secured loans. However, the interest rates are often lower than those of credit cards, making them a more affordable option for borrowing. The application process is usually straightforward, and funds can be disbursed quickly upon approval.

It’s essential to assess your credit score before applying, as it significantly influences the interest rate you’ll receive. Additionally, ensure that the monthly payments fit within your budget to avoid financial strain. Comparing offers from multiple lenders can help you secure the best terms.

Lines of credit, on the other hand, provide flexible access to funds up to a predetermined limit. You can draw from the line of credit as needed and pay interest only on the amount borrowed. This revolving credit can be particularly useful for ongoing expenses or emergencies. However, it’s crucial to use this option responsibly to prevent accumulating excessive debt.

Home Equity Loans or HELOCs

If you own a home with substantial equity, a home equity loan or a Home Equity Line of Credit (HELOC) can be viable alternatives. A home equity loan provides a lump sum at a fixed interest rate, making it suitable for large, one-time expenses.

In contrast, a HELOC offers a revolving line of credit with a variable interest rate, allowing for flexible borrowing over time. Both options typically have lower interest rates compared to unsecured loans because they are secured by your home.

This also means that failure to repay can put your home at risk. It’s important to consider closing costs and fees associated with these loans, as they can add to the overall expense. Additionally, recent tax law changes have affected the deductibility of interest on home equity loans, so consulting a tax advisor is recommended.

Before proceeding, evaluate your ability to make consistent payments and the potential impact on your financial situation.

Emergency Savings Funds

Building an emergency savings fund is a proactive approach to financial security. By setting aside funds regularly, you create a financial cushion to cover unexpected expenses such as medical bills, car repairs, or job loss.

Financial advisors often recommend saving three to six months’ worth of living expenses. Starting small, even with modest contributions, can gradually lead to a substantial safety net over time. Automating transfers to a dedicated savings account can make the process easier and more consistent.

High-yield savings accounts or money market accounts are suitable options for storing emergency funds, as they offer liquidity and better interest rates compared to regular savings accounts. Having this fund in place reduces the need to tap into retirement accounts or incur debt during emergencies, preserving your long-term financial health.

Seeking Assistance from Family or Friends

In times of financial difficulty, seeking assistance from family or friends can be a viable option. Borrowing from loved ones may come with more flexible terms and lower or no interest compared to traditional lenders.

However, it’s crucial to approach this option with transparency and a formal agreement to prevent misunderstandings or strained relationships.

Clearly outline the loan amount, repayment schedule, and any interest involved. Treat the arrangement professionally by documenting the terms in writing and adhering to the agreed-upon repayment plan. Open communication throughout the process can help maintain trust and prevent potential conflicts.

Additionally, consider the financial position of the person you’re borrowing from to ensure that providing the loan won’t cause them hardship. While this option can be helpful, it’s essential to honor commitments to preserve personal relationships.

Tips for Minimizing the Impact of a 401(k) Loan

Borrow Only What You Need

Borrowing only the amount you truly need is critical to minimizing the long-term impact on your retirement savings. Taking out more than necessary could result in higher repayments and a greater loss of compound interest on the withdrawn funds. Carefully evaluate your financial situation and determine the smallest loan amount required to address your needs.

Develop A Solid Repayment Plan

Creating a repayment plan ensures that you can manage your 401(k) loan effectively without jeopardizing your financial stability. Set a realistic budget to account for the payroll deductions and avoid missing payments. A strong plan can prevent penalties and help you stay on track to rebuild your retirement savings after repaying the loan.

Keep Contributing To Your 401(k)

Continue contributing to your 401(k) while repaying the loan. Stopping contributions while repaying your loan can significantly hinder your retirement growth. Even if it’s challenging, aim to contribute at least enough to receive any employer match. This ensures you’re not leaving free money on the table and helps maintain progress toward your long-term financial goals.

Conclusion

It is important to acknowledge that borrowing from a 401k could be a critical last resort in an emergency financial situation. I have no doubt that many people have used this option to overcome a period of financial hardship and are glad the loan provision was available.

The problem is that for many, the 401k loan is simply a way to access their funds early to spend on their “wants” as opposed to their most urgent financial needs. Borrowing from a 401k is easy. Too easy. There are no credit checks and failure to pay it back won’t wreck your credit, although it will do significant damage to your retirement savings.

During my time as a Certified Financial Planner™ I’ve seen some serious financial emergencies that warranted a 401k loan as a last resort. And, I’ve also seen some straight up terrible decisions that would make you shake your head.

Whatever the reason you might be considering a 401k loan, you need to know what you’re really getting into. Doing so can make the difference between a sound retirement nest egg and financial future filled with uncertainty and regret.

Have you ever considered borrowing from your 401(k)? Share your experiences or questions in the comments below. For more financial tips, check out our related articles, such as ‘Staying Motivated With Your Financial Plan‘ or ‘Retirement Saving: Delay Only Makes It Harder.’

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