Many companies allow their employees to borrow money from their 401(k) plans, but it’s been estimated that only about 20 percent of eligible employees have an outstanding 401(k) loan at any time. Part of the reason might be that taking a such a loan isn’t always the best solution in a cash emergency. In fact, it’s been called a last resort.
That said, there are times when borrowing from yourself through a 401(k) loan can make a lot of sense. Just be sure you understand the advantages and disadvantages of this type of loan before you sign on the dotted line, from no credit check—which is good—to lost investment growth, which is not good at all.
401(k) Loans Have Borrowing Limits
The Internal Revenue Service limits 401(k) loans to the greater of $10,000 or one half of your retirement plan balance, up to a limit of $50,000. This doesn’t mean that your plan must accept these terms, however. Your company is permitted to offer less.
When Do You Have to Start Paying the Loan Back?
You must typically agree to begin paying the loan back as soon as your next pay period. This is most often accomplished through an automatic deduction from your paycheck. You probably won’t have 30 days until your first payment.
401(k) Loans Can Be of Limited Duration
You must pay the loan off in five years or less unless you use the money to acquire a home. The length of the loan can be significantly longer if you borrow the money so you can purchase a residence, but this could present a problem if you leave your job.
You Can Skip the Credit Check
No credit check will be performed if you request a 401(k) loan because you aren’t borrowing money from another party. You’re temporarily tapping into your own retirement funds. But this doesn’t mean that you won’t pay interest.
401(k) Loans Have Competitive Interest Rates
The interest rate on a 401(k) loan is often in the neighborhood of the prime rate, which is consistent with typical consumer loans. But you’ll pay back the loan principal and the interest to yourself, not to a bank or other financial institution. The entire amount of each loan repayment goes back into your 401(k) account.
This can a particularly attractive advantage if you’re taking the loan to pay off several high-interest credit cards and loans—you’ll save yourself money overall if your 401(k) loan rate is significantly less…and you get to keep that interest money in your plan rather than give it to someone else.
Low or No Application Fees
A 401(k) loan isn’t a true loan, so any application fees are usually minimal. If your plan does have an origination fee, this usually goes to the plan administrator, however, not back into your account.
Many plans charge an origination fee of up to $75 per loan, so you could lose 7.5 percent if you borrow $1,000.
401(k) Loans Result in Lost Investment Growth
Your borrowed 401(k) money will not be invested for your retirement while it’s outstanding from your plan. You’ll forgo all potential investment gains from the borrowed funds for the duration of your loan.
Even worse, you’ll lose out on gains from compound interest. Remember, you’re borrowing from your future self, so you likely won’t break even in terms of lost investment growth by the time you retire, even when you pay back the principal and interest.
The initial 401(k) contributions you made were likely tax deductible, but you’ll have to pay the loan back with after-tax dollars. A $100 loan repayment reduces your take-home pay by $100, and you’ll pay tax on that same money again when you take the money out of your 401(k) plan during retirement.
Can You Keep Contributing to Your 401(k)?
Some plans prohibit any further pretax contributions until your loan is paid off. This can further derail your savings plan over the long haul, so consider other possible options if you really need cash.
401(k) Loans Are Dependent on Your Employment
The terms of a 401(k) loan are generally tied to your employment status with that company. The entire remaining balance of your loan will come due by the tax filing deadline for that year if you leave or are fired from your job.
It used to be that repayment of 401(k) loans had to occur within 60 days of leaving employment, but the Tax Cuts and Jobs Act (TCJA) changed this provision effective January 2018. The deadline is now the due date for that year’s tax return, including extensions. You must either repay the loan or roll the money over into another qualifying retirement account by that deadline.
Otherwise, the entire amount you’re unable to pay within that time is deemed to be a distribution. It will be subject to federal and state income tax and possibly early distribution penalties, depending on your age.
It’s Still Generally Better Than a Distribution
It’s always better to be prepared for a financial crisis with emergency funds or proper insurance, but a loan is still the preferable option if your only other source of money is an outright distribution from your 401(k). You can avoid paying the income tax and penalties you would on a distribution unless your employment is terminated during the life of the loan and you don’t meet the repayment deadline.
Of course, there are exceptions. For example, you won’t be hit with that 10 percent early withdrawal penalty before age 59 1/2 if you take the money as a distribution instead of a loan and you do so to pay unexpected medical bills. Your medical expenses must be more than 7.5 percent of your adjusted gross income, however, and withdrawals are always subject to income tax.