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Borrowing From Your 401k: Pros and Cons

December 09, 2021 · 7 minute read

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Borrowing From Your 401k: Pros and Cons

Borrowing from your 401(k) may offer some advantages (there’s no credit check to borrow your own funds, for example), but there are also disadvantages — like the potential long-term impact on your retirement nest egg.

Let’s walk through a recap of how a 401(k) plan works, how early withdrawals are different from 401(k) loans, and how to think through the pros and cons of borrowing from your 401(k).

Quick Recap: How Your 401(k) Works

Your retirement contributions to your employer-sponsored 401(k) plan are generally deducted directly from your paycheck. They’re considered pre-tax because you don’t pay tax on that money. Also, your contributions grow tax-free until you withdraw the money in retirement, which is why a 401(k) is called a tax-deferred account (similar to a 403(b) or traditional IRA).

You can take withdrawals from your 401(k) starting at age 59 ½ without incurring a penalty. But you will owe taxes on the money you withdraw in retirement.

Borrowing from your 401(k) before retirement often comes with penalties.

The wrinkle is when you try to withdraw money, or take out a loan, from your 401(k) before age 59 ½. Early withdrawals may incur a 10% penalty, depending on the circumstances (plus you’ll owe taxes on those withdrawals).

For example, let’s say you’re in a 25% tax bracket: If you take an early withdrawal of $2,000, you would owe $500 in taxes plus a 10% penalty of $200, for a total of $700.

Under certain circumstances, a withdrawal may not incur the 10% penalty, but it can be difficult to qualify for these types of withdrawal.

Now let’s look at borrowing from your 401(k), and how it’s different from an early withdrawal.

What Is a 401(k) Loan & How Does It Work?

Many 401(k) plans provide the option to take out a loan from your retirement account, and then pay it back over time, with interest. In a sense it’s similar to taking out a conventional loan from a bank — but in another way it’s not really a “loan” because you’re not going through a commercial lender, but accessing funds you’ve set aside.

Also, because you’re borrowing your own funds, the interest rate is generally lower and you don’t need a credit check to qualify.

With a 401(k) loan you don’t have to worry about owing taxes or penalties, as you would with an early withdrawal — because you’re borrowing your own money, and paying yourself back.

Nonetheless, there are federal rules, as well as employer or plan policies, that restrict 401(k) borrowing. It’s also important to understand the repayment terms for these loans.

Limits on how much you can borrow

According to IRS rules, you can borrow up to $50,000 or 50% of your vested account balance — whichever is less. If you have $20,000 in your account, for example, you can only borrow up to $10,000. (Note that in certain circumstances under the CARES Act, some loan terms may be different. If you’ve been impacted by Covid-19, be sure to get the necessary information. Some of these provisions were extended through July 2021.)

In some cases you can take out multiple loans, but plan restrictions may apply, and the total amount you can borrow is still limited to 50% of your account balance or up to $50,000, whichever is less.

So if you have $20,000 in your 401(k) and you’ve borrowed $5,000, but after a few months you realize you need more money, you’d be limited to borrowing $10,000 combined for both loans.

Spousal permission

Some plans require borrowers to get the signed consent of their spouse before the loan can be approved.

You repay the loan with interest

A 401(k) loan is repaid through an ongoing payment plan, much like any loan (e.g. monthly or quarterly). Generally you have to repay the amount you’ve borrowed within five years, though you may have more time if the loan is for a first-time home purchase. You also have to pay interest on the loan. Typically the interest rate is the prime interest rate set by the Federal Reserve plus 1%.

That said, you’re not paying interest to a lender, but rather to yourself — essentially to make up for any lost earnings you might have incurred when taking the money out of your retirement account.

For those performing military duties, loan payments may be suspended, according to the IRS.

How Does a 401(k) Loan Different From an Early Withdrawal?

When you withdraw money from your 401(k) before age 59 ½ — a.k.a. An early withdrawal — you generally owe taxes and will have to pay a 10% penalty on those funds. But you don’t have to pay the money back. It’s treated as a distribution.

In certain cases you may take an early withdrawal penalty free, if you qualify. Some common reasons include:

•   Unreimbursed medical expenses

•   A first-time home purchase

•   Qualified educational expenses

•   Disability

•   If the 401(k) plan holder is deceased

Be sure to do your research to understand the restrictions that may apply in each case.

When you borrow money from your 401(k), you sign a loan agreement that includes repayment terms. But you don’t owe taxes on that money, nor would you incur a penalty.

Recommended for first-time homebuyers: Can I Use My 401(k) to Buy a House?

Pros and Cons of Borrowing From Your 401(k)

Given the potential long-term cost of borrowing money from a bank — or taking out a high-interest payday loan or credit card advance — borrowing from your 401(k) can offer some real advantages. Just be sure to weigh the pros against the cons:

Pros

•   Efficiency. You can often obtain the funds you need more quickly when you borrow from your 401(k) versus other means.

•   Low to no credit impact. There is no credit check or other underwriting process to qualify you as a borrower because you’re withdrawing your own money. Nor is the amount of the loan listed on your credit report.

•   Lower cost. Typically, the cost to borrow money from your 401(k) is limited to a small loan origination fee.

•   You have to repay yourself. If you take an early withdrawal from your 401(k), you may lose potential earnings on that money. But because a loan requires you to repay the money, with interest, you replenish your savings and possibly make up for some of the lost growth.

•   You can keep contributing. Even as you repay the money you borrowed, those funds are not considered 401(k) contributions — meaning they don’t reduce your overall contribution limit — so you can keep saving in your 401(k) as you would normally. (Note, if you take a hardship withdrawal, you cannot contribute to your retirement account.)

Cons

•   Loss of retirement savings. Even if you repay the money you borrowed from your 401(k) with interest, this added financial commitment could hamper your ability to keep making regular contributions to your 401(k) or other retirement accounts. In addition, of course, there is the potential loss of earnings on the money you’ve borrowed.

•   Default penalties. If you don’t or can’t repay the money you borrowed on time, the remaining balance would be treated as a 401(k) disbursement under IRS rules, and you’d owe taxes on the entire amount. If you’re younger than 59 ½ , you’d also have to pay a 10% penalty.

•   Leaving your job. If you leave your job, whether you’re let go or you resign, the risk of defaulting may increase, simply because once you’ve left your employer the remainder of the loan is due in full.

   Indeed, some 86% of borrowers who left their jobs with an unpaid 401(k) loan end up defaulting, according to a 2017 study. Now borrowers have until October of the year after they leave employment to make good on the loan, but it’s important to remember that you’re on the hook for the entire amount, otherwise you’ll owe taxes on that lump sum, and possibly a 10% penalty as well.

•   Double taxation. There are no tax implications for borrowing 401(k) funds, unless you leave your job or default, as noted above. However, you will repay the loan plus interest, using after-tax dollars. This is often flagged as an example of double taxation, because you will have to pay taxes on that money again, in effect, when you withdraw the money in retirement.

Alternatives to Borrowing From Your 401(k)

If you do need cash, there may be other ways to take care of your expenses without having to tap into your 401(k). If debt is the issue, consider consolidating or refinancing your debt, or negotiating with your creditors. If you are dealing with an emergency expense, or you need to tackle home repairs, a personal loan could be right for you.

A personal loan can be used for any personal expenses, though many people use them to pay off and consolidate existing debt, cover unforeseen expenses, or pay for home renovations.

Personal loans typically come with three- to seven-year repayment periods and can have either fixed or variable interest rates. SoFi personal loans offer a range of rates based on your career, education, and credit history — and SoFi doesn’t charge loan fees.

Although personal loan interest rates might be higher than 401(k) loan rates (and you aren’t paying the money back to yourself), a personal loan could still end up costing you less in the long term, because you’re not taking money out of the market as you are when you borrow from your 401(k). Thus, your nest egg remains intact, with the potential for growth over time.

The Takeaway

While it’s generally possible to borrow money from your 401(k) plan, it’s not a step to take lightly — and it pays to weigh the pros and cons.

For example, although borrowing from your 401(k) might be a faster and cheaper way to access cash when you need it, the terms of repaying the loan are strict — 401(k) loans typically have to be repaid within five years — and there are limitations on the amount you can borrow. Also, the consequences for defaulting can be quite expensive (and the risk of defaulting rises if you leave your job with the loan unpaid). So while it’s certainly wiser to borrow from your 401(k) than to take an early withdrawal (where you’d have to pay both taxes and a penalty), there is another option, which is to consider a personal loan. SoFi offers no-fee, low-hassle personal loans that may fit the bill for whatever your personal circumstances are.


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