- Borrowing on a 401 (k) means withdrawing funds from your plan which you later pay back with interest.
- A 401 (k) loan avoids the taxes and penalties that come with outright withdrawals.
- Borrowing on a 401 (k) has drawbacks, such as suspension of contributions and the overall loss of account growth.
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Any financial expert will tell you that it’s best to keep your retirement savings until retirement. This is certainly true for one of the most common ways to save for those post-career years: employer-sponsored. 401 (k) plans.
But life can get in the way of the best investment plans. And if you have an immediate need for cash, borrowing on your 401 (k) may make the best financial sense. Especially when you compare this option to other loan alternatives – or take money out of the plan entirely.
However, there are many rules, both from the IRS and from individual employer plans, that apply to 401 (k) loans. If these are not followed, you risk having to pay taxes and penalties which can seriously hurt your finances.
Understanding exactly what borrowing from a 401 (k) entails is essential in determining whether the strategy is right for you. Let’s take a closer look.
What is a 401 (k) loan?
In a 401 (k) pension plan, you make regular pre-tax contributions and the money grows tax-free. In return for these tax benefits, you must follow several IRS rules, the main one of which is no withdrawal without penalty until age 59 and a half. If you make an early withdrawal, you will be subject to a mandatory 20% federal withholding tax and, in most cases, a 10% penalty tax.
Essentially, a 401 (k) loan is a way to withdraw money from your own account without paying those taxes or penalties. You are not charged because it is only a temporary withdrawal: you will end up returning the money. And you won’t permanently deplete your retirement savings.
You will pay interest on the amount you subscribe, but that money goes back to the plan account. So, in effect, you are both the borrower and the lender of a 401 (k) loan.
IRS regulations govern all 401 (k) plans, but employers also have some flexibility to impose their own rules and restrictions. Most employers who offer 401 (k) plans allow 401 (k) loans, says Gregg Levinson, senior consultant at Willis Towers Watson. He estimates that about a third of 401 (k) (k) participants are borrowing from their accounts at any given time (not counting the COVID-19 pandemic year of 2020).
Will my employer know if I take out a 401 (k) loan?
Your employer should be notified if you plan to borrow against your 401 (k) loan – the withdrawal and repayment process is set up through them. This doesn’t mean that the entire company or your immediate boss will necessarily know. Only, perhaps, the payroll department.
How to borrow from a 401 (k)
Your first step when considering borrowing from your 401 (k) is to contact your employer’s benefits department or 401 (k) plan provider for details on how your plan’s loans work (assuming , of course, that they are offered in the first place).
Here’s what to look for in 401 (k) lending rules:
- Borrowing limits. The IRS requires that you cannot borrow more than 50% of the value of your account or $ 50,000, whichever is less. Some employers and plans will also impose a minimum loan amount, say at least $ 1,000.
- Interest. Your interest rate is determined by your employer but must be “reasonable” and similar to the rate you would find at a financial institution, according to the IRS rules. In most cases, employers charge the prime rate plus one percentage point.
- Refund. IRS rules require your 401 (k) loan to be repaid in full, with interest, within five years in equal installments consisting of principal and interest paid at least quarterly. Your own plan can follow these conditions or impose more stringent ones. Many employers use payroll deductions for reimbursements. Your employer may also allow longer repayment limits, as recommended by the IRS, if you use the loan to purchase a primary home, sometimes up to 25 years.
- Number of loans authorized. How many loans can you take out with your 401 (k) plan? Again, it depends on your employer. Most of them only allow one at a time; you must repay an amount in full before they allow you to borrow again. So carefully weigh how much you will need. The IRS itself allows simultaneous loans, as long as the combined amount does not exceed general limits.
As long as you stick to the mandates, you should be fine. But if you don’t, your loan could be considered a withdrawal, and tax and penalty payments will follow.
Is it smart to borrow from a 401 (k) plan?
Compared to other financing methods, borrowing from a 401 (k) plan has its advantages. On the positive side, a 401 (k) loan offers:
- No need for approval. It’s your money, so it’s automatic. No loan application or credit check. And 401 (k) funds borrowed don’t show up on your credit report as debt.
- Quick access to funds. Often times you can get the money back within two weeks.
- Interest rates often lower than those charged by credit cards and many personal loans offered by banks.
- Benefit from the interest. You pay yourself to borrow, instead of a lender. Because it goes into the account, the interest is sort of a windfall, not just an expense.
- No early repayment penalty. Unlike some consumer loans, most plans do not charge a fee for prepaid loans.
What are the disadvantages of borrowing on a 401 (k)?
401 (k) s loans also have their drawbacks. The disadvantages include:
- Loss of tax-deferred income. Withdrawing money from your account, obviously, shrinks it and its earning potential, especially if you take the full five years to pay off the loan. The overall effect on your retirement savings will depend on how much you borrow, how long it takes to pay it back, and the state of the stock market. Some plans do not allow you to make 401 (k) re-contributions until the loan is repaid, further hampering the ability to compound retirement savings.
- Double taxation. Loan repayments and interest are made in after-tax dollars, unlike dollars used for contributions. But they are not distinguished in the count; everything goes back to the same pre-tax pot. So when you eventually start receiving regular distributions from your plan, you will pay tax on that money; in effect, you are taxed twice on interest.
- Sudden refund. In most cases, if you leave your employer for any reason, you will need to pay off the loan in full, usually within one to six months, depending on the plan rules and the date of your last payment. If you don’t, your former employer and the IRS will treat the loan as a distribution. You will then owe income tax on the amount and, if you are under 59 and a half, a penalty of 10%. (For Roth 401 (k) s, you probably won’t owe taxes, but you will have to pay the 10% penalty.)
“People often underestimate how long they will be with an employer and find themselves in the position of having to pay the full loan amount or face a tax bill and significant penalties,” says Levinson.
The financial report
Most financial experts agree that taking out a 401 (k) loan should be a last resort. Older employees, who are past the penalty years, might find that taking a distribution might actually work better for them.
Nonetheless, borrowing from your 401 (k) plan may be an option if you need cash quickly. This is certainly a better solution than an outright withdrawal, especially if you are under 59 and a half, which incurs penalties as well as taxes.
Before borrowing your 401 (k), it’s important to consider the pros and cons. Understanding how 401 (k) loans work, the consequences of leaving your employer or losing your job before repayment, and the opportunity risks of using your retirement savings early are all key considerations.
