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If you find yourself in a financial crunch, you might consider borrowing from your 401(k). Trouble is, while a 401(k) loan could be faster and cheaper than other types of credit, you could also be jeopardizing your retirement goals.
Before you take out a 401(k) loan, it’s important to know the pros and cons—and possible alternatives—so you can make an informed borrowing decision.
Pros and Cons of 401(k) Loans
Pros of 401(k) Loans | Cons of 401(k) Loans |
---|---|
Simple application process | The plan must allow loans |
No taxes or penalties | Loans have limits |
Potentially lower interest rates than traditional loans | Strict repayment schedules |
No impact on your credit report | Can’t discharge 401(k) loans in bankruptcy |
Repay with payroll deductions | Payment schedule speeds up if you leave your employer |
Advantages of Borrowing from Your 401(k)
When cash is tight and options are few, a 401(k) loan can help you quickly bridge a financial gap—and with notable benefits. Not only do you get to borrow from yourself and pay yourself back with interest.
You can keep contributing to your 401(k) while you pay the loan back—an option that may not be available if you take a hardship withdrawal.
1. No lengthy loan applications
Since you’re borrowing money from yourself, there’s no exhausting loan application to take out a loan from your 401(k).
While you’ll need to provide some basic information to your plan administrator, it’s not nearly as much as you’d need to give a bank. The caveat? If you’re married, some 401(k) plans require spousal approval on loan applications.
2. Avoid taxes and penalties
While hardship withdrawals from a 401(k) get taxed as ordinary income and come with a 10% early withdrawal penalty, loans don’t suffer the same fate. You’ll generally avoid taxes and penalties if you borrow from your 401(k).
One exception is if you default on your loan. In that case, you’ll pay the penalty and taxes if you’re under the age of 59 ½.
3. Lower borrowing costs
You’ll still pay interest on a loan from your 401(k), but you could save compared with interest rates at traditional lenders. A bonus? The interest you pay goes into your account instead of your bank’s coffers.
4. No credit impact
Borrowing from your 401(k) rarely comes with an inquiry into your credit report, and loans aren’t reported to the three major credit bureaus.
If you’ve found qualifying for traditional loans difficult because of your credit score, a credit check-free loan from your 401(k) could be a saving grace.
5. Enjoy automatic deductions
Just as your 401(k) contributions get auto-deducted from your paycheck, so are your loan repayments. Putting your payments on autopilot keeps your loan current and more of your money working in the market.
Disadvantages of Borrowing from your 401(k)
While it’s pretty simple to borrow from your 401(k), that doesn’t mean it’s a process without its pitfalls. When available, loans from a 401(k) have limits, rules and a few quirks.
1. Your plan must allow loans
Unfortunately, not all 401(k) plans enable loans. A short conversation with your benefits department or plan administrator can explain your plan’s loan policy.
2. Loans have limits
Even if you can borrow from your 401(k), the IRS sets loan limits. At present, you can borrow up to 50% of your vested account balance or $50,000—whichever is less. Some plans offer exceptions if you have a vested balance of less than $10,000, but it’s not the norm.
3. No bankruptcy protection
Of all the debt types that get discharged during bankruptcy, 401(k) loans aren’t one of them. If you file for bankruptcy, you’ll still have to repay your 401(k) loan or face taxes and early withdrawal penalties.
4. Planning to leave your job? Be careful.
If you leave your job, willingly or not, your 401(k) loan will convert to an accelerated repayment schedule. Depending on your plan, you may need to pay the funds back soon after your severance date.
If your plan doesn’t have a repayment plan specific to departing employees, you’re bound by IRS rules. You’ll still need to repay your loan balance in full by tax day the following year.
5. Opportunity costs can be hefty
Any time you pull your money out of the market, you’re missing out on potential gains and the magic of compounding returns.
If you took out a one-year, $15,000 loan from your 401(k) on Jan. 1, 2021, with a 4.25% interest rate, you would pay back $15,347. If you’d left the money invested in an instead, then you would have $19,034 in your account. Taking out a loan means that you would missed out on a more than $3,800 return.
Alternatives to borrowing from a 401(k)
Before you take out a loan from your 401(k) and potentially jeopardize your retirement savings, it’s important to explore other options.
Personal loans
A personal loan could help prevent the opportunity cost of pulling your money out of the market. While your application will be more in-depth, many online lenders like SoFi and Marcus by Goldman Sachs offer lightning-fast qualifications and display your interest rate without a hard credit pull.
HELOC or home equity loan
If borrowing from yourself sounds attractive, you may be able to use your home equity instead of a 401(k) to access the cash you need. A home equity line of credit (HELOC) or home equity loan can offer a competitive interest rate and more flexible loan terms.
If you qualify for a HELOC, you can also draw on those funds again once you’ve paid the line back in full—you won’t even have to re-qualify.
Debt counseling
If you’re eyeing a 401(k) loan to repay high-interest debt, consider debt counseling. Unlike predatory debt relief services with astronomical costs, credit counselors are nonprofit organizations with low fees and potentially big impacts across your financial life.
These counselors will work with you and your creditors to establish repayment plans. They can also help you build better money management habits to prevent future run-ins with overwhelming debt.
Should You Borrow from Your 401(k)?
While it’s rarely wise to raid your retirement savings, there can be times when it makes sense to use your 401(k) for a much-needed loan.
When to Choose a 401(k) Loan
- You can’t beat the price. If your 401(k) offers a loan at 4%, but your bank can’t offer better than 8%, borrowing from your 401(k) could be a strong consideration.
- Speed and convenience are a priority. With no credit checks and fast access to funds, these loans can help those on tight timelines.
- You’re out of other options. If other sources of money have come up dry, your 401(k) loan can save the day.
When to Avoid a 401(k) Loan
- You have great credit. You can keep your retirement savings in the market and still score great rates on personal loans or a HELOC.
- All signs point to a bull market. You’ll likely reinvest at a higher cost in rising markets as you repay your loan.
And whether you end up borrowing from your 401(k) or not, you now know how these loans can impact your finances—along with the alternatives.
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