Aaron Cirksena, founder and CEO of MDRN Capital, warns that when considering taking out a 401(k) loan, you may think you have no other option or may be intrigued if the interest rate is low, but generally, it does more harm than good.
What Is a 401(k) Loan?
A 401(k) loan allows you to borrow money from your own employer-sponsored 401(k) retirement account. As a general rule, you can use the loan for any purpose, such as covering medical expenses or paying off debt. The loan must be paid back, with interest, over time and your plan administrator sets the terms. Essentially, you are borrowing from yourself and paying yourself back with interest. Depending on your employer’s plan, you could take out as much as 50 percent of your vested account balance or $50,000, whichever is less, according to the IRS, unless 50 percent of the vested balance is less than $10,000. In that case, you can borrow up to $10,000.“One important factor to consider is the interest rate,” says Jackie Reeves, Director of Retirement Plan Services with Bryn Mawr Trust. “Even though you’re technically paying interest back to yourself, assessing whether this makes economic sense in the long run is wise.” She goes on to say that since a loan is not a withdrawal, you would not face income tax or the 10 percent early withdrawal penalty, provided you repay the loan as agreed.
“However, one drawback is that borrowing from your 401(k) reduces the compounding growth potential of your retirement savings until the loan is fully repaid. This means your retirement balance may grow more slowly due to the missing investment gains while the loan amount is out of the market.”
In most cases, you must pay back the amount you borrow from your 401(k) within five years of taking out the loan—the longest repayment period the government allows. This includes any interest paid out. Your plan may also set the number of loans you can take out or have outstanding at any one time. Some plans allow you to contribute to your 401(k) while repaying the loan; others don’t.
Most 401(k) employer-sponsored plans allow automatic repayments through payroll deductions. Putting your payments on autopilot keeps your loan current. However, it also means your paycheck will be smaller until the loan and interest are paid off. And, although traditional 401(k) contributions are tax-deferred, there is no tax break on your loan repayments with a 401(k) loan. Instead, the money is taxed before it is deposited into your 401(k) and taxed again when you take the money out in retirement.
Pros of a 401(k) Loan
- With a 401(k) loan, you don’t have to pay taxes and penalties like with hardship withdrawals that are taxed as ordinary income and come with a 10 percent early withdrawal penalty. Plus, any interest you pay on the loan goes right back into your 401(k) account. One exception is if you default on your loan. If that happens, you’ll pay a penalty and taxes if you’re under the age of 59½.
- If you miss a payment or default on your 401(k) loan, it won’t impact your credit score. That’s because defaulted loans are not typically reported to credit bureaus.
- Since you’re essentially borrowing from yourself, the application process is quick and easy, unlike applying for a traditional loan. However, if you’re married, some plans may require spousal approval.
- If you use the loan for something that improves your financial standing in the long run, it could be beneficial. For example, paying off credit cards or other high-interest debt, therefore reducing the amount of interest you owe to lenders.
Cons of a 401(k) Loan
- Not all employer-sponsored plans allow 401(k) loans.
- Leave your current job, and you might have to repay your loan in full before exiting the door. If your plan doesn’t state a specific protocol for departing employees, you’re bound by IRS rules.
- Default on the loan, and you’ll owe both a 10 percent penalty and taxes on the outstanding balance if you’re under 59½. You’ll also lose out on any potential growth in your tax-advantaged account.
- The IRS sets loan limits, so in most cases, you can only borrow up to 50 percent of your vested account balance or $50,000—whichever is less.
- You aren’t protected by bankruptcy. If you file for bankruptcy, you’ll still have to repay your 401(k) loan or face taxes and early withdrawal penalties.
