What You Need to Know Before Borrowing from Your 401(k)
Financial setbacks may have you tempted to borrow money from your 401(k), especially because banks and other lenders have made it harder for you to borrow money by tightening up their lending standards. If you participate in a 401(k) plan, you may be able to borrow up to $50,000, or half of the balance in the plan (whichever is less). But that doesn’t mean that option is right for your situation.
Know the Consequences of Borrowing
Take the following into account before borrowing from your 401(k):
- If you borrow from your 401(k) and then are terminated by your employer, you are obligated to pay back the entire outstanding balance of your 401(k) loan typically within 60 days. Whatever amount you do not repay is considered a retirement distribution and may be subject to income tax and possibly a 10 percent early withdrawal penalty.
- A 401(k) loan is paid with after-tax dollars, unlike the pretax contributions that go into your 401(k). When you take that money out in retirement, it will be taxed—again. So a loan results in double taxation for you as the borrower.
- While you are repaying your 401(k) loan, you may or may not be allowed to make your normal pretax contributions, depending on your employer's plan rules. If your employer will not allow you to make new contributions while you have a loan outstanding, you lose the opportunity to increase your 401(k) balance. Keep in mind that if you are not making any pretax contributions, your income taxes may rise during this period as well.
Given the chances of potential penalties, taxes, and decreased saving opportunities, does it ever make sense to take a loan from your 401(k)? After all, interest rates on these loans are reasonable, perhaps half as much as what a bank might charge you for a personal loan.
If your cash flow is really tight and you are making big payments on debts with high interest rates, using a 401(k) loan may take some pressure off your monthly payments. Consolidating several high-interest rate debts into one lower-rate debt is one of the primary reasons workers take out 401(k) loans.
Consider the Alternatives
Always keep in mind, however, that the primary purpose of your 401(k) plan is retirement savings, not borrowing. Instead, consider these alternatives to a 401(k) loan:
- If you have equity in your home, consider a home equity loan as the interest paid on the loan may be tax-deductible.
- If you have experienced special or extremely challenging circumstances, you may be able to take a taxable withdrawal from your 401(k), rather than a loan. In certain hardship situations such as medical expenses, you can avoid the 10 percent early withdrawal penalty if you are under age 59 ½.
- If you have an IRA, you can look into 72(t) withdrawals, which also allow you to avoid the 10 percent early withdrawal penalty. As with a hardship distribution from a 401(k), both types of withdrawals still are taxable.