Key takeaways:
- Borrowing against a 401(k) can easily cover a large expense if getting financing elsewhere isn’t possible.
- Taking from your retirement fund with a 401(k) loan avoids a credit check and can save you on taxes, penalties, and interest if paid off properly.
- Mishandling of a 401(k) loan can cost you more money. You could miss out on investment gains, and defaulting on the loan can have serious tax implications.
When you’re looking to loan a large amount of money, borrowing from your retirement savings can be a suitable financial strategy if done right. Although best used as a safety net, a 401(k) loan may be your only option. This is especially true if you’re someone with a low credit score or high-interest debt and experience difficulty getting a loan.
Borrowing against a 401(k) can help quickly cover a large expense, but if not handled properly, it can hurt your long-term financial wellbeing. Have a plan for how you’ll repay the loan to ensure you’re on track for building security in your later years and planning a successful retirement.
Before taking from important retirement funds, learn exactly how to borrow money from your 401(k) and the potential downfalls to prepare for.
What is a 401(k) loan?
Borrowing money from your 401(k) retirement savings with a loan is a low-interest way to get a large amount of money quickly. It’s a loan against a retirement account for those with a 401(k) through their current employer. You don’t have to pay taxes or penalties when you take out a 401(k) loan, but you’ll have to pay it back within a specified time frame.
Pro tip: If your plan doesn’t offer loans, you might be able to access your money with a hardship withdrawal. This method permanently removes funds from your 401(k) for immediate use, but you’ll have extra taxes to pay and penalties may apply.
When should you use a 401(k) loan?
A 401(k) loan can be helpful in a variety of ways. It all depends on what works best for your financial situation. But due to the downfalls you could face if the loan isn’t treated properly, it’s best not to sabotage your retirement in certain cases.
Some potential uses for a 401(k) loan can include:
- Medical expenses or high-deductible health plans
- Consolidating high-interest debt
- Funding a down payment on a house
- Paying household bills and expenses
- Paying education expenses
It’s important to learn how borrowing from your 401(k) can affect more than paying for one type of debt.
401(k) loan rules
Like any type of loan, there are rules to abide by for a 401(k) loan. You’ll want to be aware of them to ensure it works for your future plans.
How much are you allowed to borrow from your 401(k)?
The government limits how much workers can borrow from 401(k) plans. With a 401(k) loan, you’re usually allowed to borrow from your account in a couple of ways:
- 50% of the vested account balance
- Up to $50,000
The total amount you can take is whichever number is less for you, plus interest.
If there are other money types in your 401(k), like if your employer matches your contributions, those funds may not be available to borrow.
Pro tip: You can’t borrow from previous 401(k) job funds, however, you might be able to roll money over to your current job’s 401(k). There will likely be a waiting period, but increasing your balance to borrow from is worth looking into.
What are the requirements for paying back a 401(k) loan?
The typical payback period for a 401(k) loan is 5 years. There’s no penalty for paying off the loan sooner. You may be able to get longer loans under special circumstances, such as if you used money from the loan to pay for a primary residence.
You can pay back the loan total via payroll deduction, similar to how you put money into your 401(k) account.
How does it work when you borrow against your 401(k)?
If you’ve decided borrowing from your 401(k) is right for you, these steps will help you acquire your loan:
1. Check with your plan administrator
First, find out if loans are available in your plan. Not every 401(k) offers loans, so check with your employer’s HR or benefits department beforehand.
2. Find out the terms
You can move forward with the process if your plan allows loans, you’re eligible to borrow, and have a vested balance in the plan. Every employer’s plan has different rules for 401(k) loans, so find out the terms and conditions for yours.
3. Fill out the required paperwork
To set up the loan, you can get paperwork from your employer or, in some cases, go to the website you use to handle your 401(k). The form will calculate your interest rate, payroll deduction payments, and only allow the maximum amount of money you’re entitled to.
4. Receive the 401(k) loan
Once your loan gets approved, the loan amount will likely be included in your next paycheck or sooner. The money is effectively removed from the stock market or wherever you have your 401(k) funds invested.
5. Make payments on the loan
Depending on your plan, you’ll need to start making monthly or quarterly payments. Aim
to pay off the loan as quickly as possible to get your retirement investment gains back.
Pro tip: If you have sufficient funds, continue to make contributions toward your regular retirement plan. A 401(k) loan can quickly stunt your retirement growth and potentially make you miss out on up to 5 years of investment gains.
Benefits of taking out a 401(k) loan
Borrowing against your 401(k) isn’t the most ideal. But there are ways it can benefit you, especially compared to an early 401(k) withdrawal.
- Avoid paying taxes and penalties. Unlike 401(k) withdrawals, you don’t have to pay taxes and penalties when you take out a 401(k) loan.
- Helps you save on interest. With a 401(k) loan, you’re essentially borrowing from yourself. The interest you pay on the loan goes back into your retirement plan account rather than a financial institution. What’s more, 401(k) loans may have a lower interest rate than what you could get at a bank for a different type of loan.
- Won’t damage your credit score. When you borrow against a 401(k), it doesn’t trigger a hard inquiry or credit check. Even if you miss a payment or default on your loan, payments on 401(k) loans aren’t tracked by the national credit bureaus (Experian®, Equifax®, and Transunion®). This makes a 401(k) loan a great option for those who have bad credit or want to work on their credit without another loan on their credit report.
Risks of taking out a 401(k) loan
Before deciding to borrow money from your 401(k), consider potential drawbacks if the loan and repayment process doesn’t go smoothly.
- Tax implications. If you default on your loan, you could face serious tax consequences. In 401(k) loan rules, the outstanding loan balance is treated as taxable income by the IRS.
- The loan depends on your job. If you lose your job or change employers while borrowing against your 401(k), you’re required to repay the loan within an accelerated grace period of typically only a few months. Otherwise, you get hit with penalties, plus growth distribution tax.
- Decrease in retirement savings. Often, retirement savings get put on hold for borrowers until the 401(k) loan is repaid. Payroll deductions could be up to 5 years, disrupting the process. It reduces your contributions along with your employer’s matching contributions.
- Loss of investment value. During the payback period, while your 401(k) account has less money, you have less to participate in market returns. These funds should be invested and accumulate wealth for your retirement.
- Early withdrawal fees. You’ll be charged a 10% penalty for making an early withdrawal from your 401(k) on any unpaid portion of the loan—unless you’re older than 59.
Pro tip: To avoid jeopardizing your retirement funds, it may be better to find an alternative way to borrow money. Consider tapping into savings or an emergency fund, taking out a personal loan, or withdrawing from a Roth IRA.
Planning for the future
After learning how to borrow from a 401(k), you may decide it’s right for you. But because of the risks, choose it carefully. This should be a last resort when you’re in need of a large sum of money and paying off various debts.
If you’re considering taking from your retirement savings, weigh the pros and cons of a 401(k) loan first. Remember to have a plan for helping your finances stay on track while paying off the loan. Pay the loan off on time, avoid borrowing more than you need or borrowing too many times, and continue saving for retirement.
Even with the risks of borrowing against a 401(k), taking the right steps can set you up for a strong financial future.
Won't affect your credit score¹