What You Need to Know Before Taking out a 401(K) Loan

Borrowing money from your 401(k) account has both pros and cons. Think over the situation before you take action. Maklay62/Pixabay

Financial hardships happen, and can be experienced by anyone. Unexpected layoffs, putting kids through school, and the changes caused by COVID-19 to name a few.

Regardless of the reason, when money is needed, there is no shortage of options available for obtaining emergency funds. Borrowing from a retirement fund, specifically a 401(k), is an option many people choose.

You are essentially borrowing money from yourself via your retirement funds, and paying yourself back, as opposed to acquiring a loan from a more traditional source such as a bank. While the process is fairly straightforward, the necessities and reasoning behind it and the potential repercussions should be considered before transferring any money.

What Is a 401(k) Loan?

A 401(k) loan comes with terms just like any other type of loan. Depending on the amount borrowed, a repayment plan and an interest rate will be set. The IRS capped the time to pay back a 401(k) loan at five years, although there are exceptions. For example, if the funds borrowed are used to buy your main residence, you will be granted more time to repay the loan.

When borrowing from your 401(k), it is essential to understand the tax implications. A traditional 401(k) is funded with pre-tax dollars. When repaying the loan, the funds will come from after-tax earnings. Be aware of this before making a final decision.

Ways to Borrow

You have two options when borrowing from a 401(k). One, is a hardship withdrawal, in which you face a 10 percent early withdrawal penalty (if prior to the age of 59 1/2) in addition to regular income tax. Because of these hefty tax consequences, an early withdrawal is not the first choice.

The second option is borrowing from your 401(k). You are not subject to a credit check, and should you default on this loan, it will not be reported to any of the credit bureaus. It’s a solid option for short-term liquidity, allows flexibility on repayment terms, and is typically fast.

When you really need cash, borrowing from your 401(k) is an option. Vitalii Vodolazskyi/Shutterstock

You are allowed a maximum loan amount of $50,000 or 50 percent of the assets, whichever is less. This amount is increased to $100,000 if you are purchasing your main home.

Furthermore, when you repay this loan, you are essentially repaying yourself, as opposed to paying a higher interest loan from a more traditional lender.

Effect on Your Retirement Funds

When analyzing the potential disadvantages of borrowing from a 401(k), perhaps the most glaring one is how it hampers the growth of your retirement fund.

Simply put, when you take money out of your retirement account, you have less money and interest accruing in your account. Underestimating the power of compound interest is a mistake that many people make.

In addition to the money taken out for the loan, some 401(k) plans have stipulations that suspend any subsequent contributions until the loan is repaid in full. So while the amount withdrawn for the loan will not be subject to any new growth and will exacerbate the capacity for profitable compound interest, your loan’s principal may potentially be handicapped for the course of the loan.

Let’s say you took the maximum allowed time of five years or longer if you are purchasing a home, to pay back the loan. The lack of activity could potentially damage your retirement savings and be difficult or impossible to recover from.

There are pros and cons to borrowing from your 401(k) account. Kevin Schneider/Pixabay

For example, let’s say you have $300,000 in your 401(k), and all of it is invested in the S&P 500. You decided to take a $50,000 loan from your retirement savings in January of 2017 on a five-year term, and were not allowed to contribute until the loan ended in January 2022.

Prior to taking out the loan, you were contributing $13,000 annually. If we break down the numbers and use the historical returns of how the S&P performed between 2017-2021, it will look something like this:

• Your principal amount is reduced from $300,000 to $250,000. There is now $50,000 less, which will severely impact the amount of compound interest earned.
• In the five years in which you are not allowed to contribute, your bi-weekly contributions would have amounted to $65,000. So your account will be down by $115,000.
• With contributions suspended for five years, based on the S&P 500 performance between 2017-2021, the principal amount of $250,000 would have grown to roughly $530,000. Had you not taken out the loan and continued to contribute towards the $300,000 in your retirement savings, at the end of the same five-year period, your 401(k) would have grown to nearly $750,000. Not only is there a tremendous difference in growth resulting in a substantial disparity in the final figures (over 4 times the amount of the initial loan), but the growth of your retirement funds will be negatively affected in subsequent years.

Additional Negative Factors

The potentially negative effect on growth is just one consequence of taking out a loan. Timely repayment of any loan from a 401(k) is crucial. If your loan is not repaid on time, it can potentially turn into a distribution, resulting in a hefty tax bill and additional penalties.

If you leave your job, the timeline for paying back your loan will be moved up. According to the new tax law, anyone who borrows from their 401(k) and ceases working for the employer that sponsored their plan, has until the due date of their federal income tax return to repay the loan. For example, if you had a loan out and left your employer in March 2022, you would have until April 15, 2023, to repay the loan in order to avoid defaulting or additional penalties.

Understand the rules and policies well before taking money from your 401(k) account. Fotolia

Weigh Your Options

Financial hardships can happen, and there are many solutions to bridge the gap. While some options, such as payday loans, are seldom a good choice, there is a lot more nuance when it comes to borrowing from your 401(k). In the context of short-term liquidity, you would be hard-pressed to find a quicker and easier option. If you intend to pay the loan back quickly, particularly if your contributions are suspended, this option becomes more attractive.

If your financial situation requires a loan in the first place, you may not be able to repay the loan swiftly. This is why borrowing from your 401(k) should not be made without thoughtful consideration.

There are however, conditions in which taking a 401(k) loan is advantageous, such as making a down payment on a home or paying off a high-interest debt. Although these situations are more plausible, they are not immune to consequences. Regardless of how great an investment a house may be, pulling out five or even six figures from your 401(k) for a down payment will undeniably have dire effects on your retirement funds, potentially for years.

Should you decide to borrow from your 401(k), it’s a simple process and typically is done quickly. Contact your HR department to begin the process after ensuring that your employer’s plan allows loans to be taken (the vast majority do). Most plans also have online means to do this, like a 401(k) online portal.

Filling out the required paperwork shouldn’t be too cumbersome. Take this time to see if there are any other specifications unique to your plan and repayment terms. When doing the paperwork, you can select how you want to make repayments to your loan (online or taken out of your paycheck).

You can also decide how you'd like to receive the funds. Although most plans make direct deposits into your bank account, you can receive a check by mail as well, though this option will take longer and be subject to delivery delays. If you decide on direct deposit, the money is typically there within a few business days. The speed of the transfer is one of the better aspects of a 401(k) loan.

The Epoch Times Copyright © 2022 The views and opinions expressed are only those of the authors. They are meant for general informational purposes only and should not be construed or interpreted as a recommendation or solicitation. The Epoch Times does not provide investment, tax, legal, financial planning, estate planning, or any other personal finance advice. The Epoch Times holds no liability for the accuracy or timeliness of the information provided.