Personal Finance

What is a 401(k) Loan and is it a Good Idea?

For many employees, their 401(k) plan is their main means of saving for retirement and it may also represent the bulk of their net worth. Given this reality, it’s no wonder that some individuals might look at their retirement savings and wish that they could utilize some of those funds today. Well, as it turns out, you just might be able to.

With 401(k) loans, participants in most plans can temporarily tap their accounts in order to access money for a number of needs. So how do these loans work and are they really a good idea? Let’s take a look at a few things you should know about borrowing from your 401(k).

How Do 401(k) Loans Work?

What is a 401(k) loan?

Under many employer-sponsored 401(k) plans, workers are able to borrow from funds they’ve contributed (or have vested through profit sharing, employer matching, etc.) to their accounts. Therefore, unlike a regular loan, the lender is actually the employee themselves. While participants may be able to set their own repayment terms including the length of the loan, most are capped at a five-year repayment timeframe. However, this can be extended if the funds are being used to purchase your primary residence.

For the record, while they are most commonly referred to as 401(k) loans, borrowing may also be possible for some similar plans including 403(b)s and 457(b)s.

401(k) loan limits

Like most things involving tax-advantaged accounts, there are rules to how much you can borrow from your 401(k). Typically you can not take out more than 50% of your vested account balance. Moreover, regardless of how large your vested balance is, you may not borrow more than $50,000 from your account. However, as of March 2020 (as part of the CARES Act), the $50,000 limit has doubled to $100,000 and up to 100% of your vested balance. This adjustment is currently slated to remain in effect until September 23rd, 2020.

Applying for a loan

To inquire about a 401(k) loan, the best place to start is your plan issuers website. Often times, you’ll be able to request a loan from their online portal and select the terms of your loan. However, if you have questions about a 401(k) loan option or don’t see any information online, it may be worth reaching out to your company’s human resources or payroll department.

Potential Uses for Borrowed Funds

When borrowing from your 401(k), there’s really no shortage of what you can use the money for. Indeed, the IRS is surprisingly lax on rules regarding these types of loans. Nevertheless, let’s take a quick look at some of the many ways employees might be able to utilize their loans:

Paying off credit card debt

One popular potential use of 401(k) loan funds is debt consolidation. This simply means using the money to pay off your existing credit card debt. Often times this approach is attractive because the high interest rates that cards carry can significantly add to the amount you end up paying on your debt — not to mention the amount of time it takes you to pay it all off.

Down payment on a home

Another common strategy is to use 401(k) loans as a means of making a down payment on a home. Typically, it is advised that buyers put 20% down on the purchase of a home. Moreover, this amount may be required to avoid paying private mortgage insurance (PMI). Of course, this percentage can amount to a big chunk of change — and waiting until you can save up the money likely means missing out on the home you’re eyeing. Therefore, it’s understandable that some homebuyers might see borrowing from their 401(k) as a solution. Also, remember that using funds to purchase your primary residence may entitle you to extend your loan terms beyond five years.

Home repairs or renovation

Speaking of homes, whether you’re buying a fixer upper, making updates before selling your home, or just looking to change things up, a remodel may be in order. Similarly, since things can always go wrong, some unexpected repairs might also be necessary. In either case, major projects can climb into the five-figure range. So, once again, taking a 401(k) loan may prove to be an option for funding these remodels or repairs.

Starting a business

If you’ve ever considered starting your own business — whether as a side hustle or as a hopefully full-time replacement — one thing standing in your way may be capital. To help you get up and running, you may consider leveraging a 401(k) loan. However, if you plan on using the money to start a business and then leave your current job, you may run into some issues (we’ll cover more on that in the next section).

Vacation

Everyone needs a break once in a while. That’s why some might consider using a small 401(k) loan to book their dream getaway. This plan can be effective for scoring a good deal by booking at the right time. As an added bonus, with this route, you won’t need to worry about racking up credit card debt while away and can focus on relaxing instead.

Pros and Cons of 401(k) Loans

When it comes to borrowing money from your 401(k), there are both advantages and drawbacks to be aware of. Making things even trickier, while the benefits may make it seems like a slam dunk of an idea, some might overlook the risks that might sully their plans. With that, here are some of the key pros and cons inherent to 401(k) loans:

Low interest rate

Perhaps the biggest advantage most people see in obtaining a 401(k) loan is that the interest rates are often low compared to traditional personal loans or other options. Plus, since the interest on the loan actually goes back into your account, it’s more like you’re paying yourself back. To most, that likely sounds a lot more attractive than paying interest to a bank, credit card company, or other lenders.

No credit checks

One reason why 401(k) loans are often more affordable than regular loans is because they aren’t impacted by your credit scores. In fact, most 401(k) loans won’t require any credit checks at all. This could not only be an advantage for those who are in the process of rebuilding their credit but is also noteworthy for those concerned about adding a potential “hard inquiry” to their credit report.

Automated payments

Just as your 401(k) contributions are deducted right from your paycheck, so are your 401(k) loan payments. For most people, this aspect could actually be helpful as it will ensure that they’re keeping up with their payments and because they won’t need to worry about any due dates or late payments. Similarly, having the funds deducted before they even reach your bank account is often easier for borrowers to manage than forcing themselves to take money out each month. Of course, others might need to get used to seeing small paychecks until their loan is repaid and may wish to have more control over their payment. For these people, a 401(k) loan might not be the best path.

Opportunity costs

Transitioning to the drawbacks of 401(k) loans, the fear is that, by pulling money out of your account today, you could be missing out on money that would benefit you in retirement. That’s because, while funds are being repaid, you might be missing out on market gains. On top of that, thanks to compounding, the total opportunity lost may be larger than you realize.

It should be noted that experts disagree on how impactful this piece of the puzzle actually is. Moreover, the market conditions at the time of your withdrawal and during the life of your loan can also lead results to vary greatly from person to person — with some perhaps even seeing benefits from the move. Still, this is something that should be considered when determining if a 401(k) loan is right for you.

Penalties and problems if you lose your job

Finally, the largest risk that comes with borrowing from your 401(k) involves what happens should you lose your job. In most cases, if you are terminated and still have an outstanding loan balance, you’ll be required to pay back the rest. The good news is that you now have until the start of the next tax year to fully repay your loan whereas, prior to 2017, you were only allotted 60 days.

In the event you don’t repay your loan or roll the loan over to another qualifying plan within the time given, the remaining balance will be considered a distribution. This would not only subject the borrower to taxes associated with retirement distributions but, if they’re under 59 1/2 years old, a 10% early withdrawal penalty would also apply. Howevever, there are currently some exceptions to this due to the CARES Act passed in March 2020.

Although they may not be discussed nearly as often as other types of loans, 401(k) loans may be a decent option for workers in need of cash. That may be why the recent CARES Act made it even easier for employees to borrow from their 401(k)s with increased limits and some waived penalties. Therefore, whether you’re looking to pay off high-interest credit card debt, purchase a home, or just get through these uncertain times, it may be worth exploring whether a 401(k) loan is right for you.

Also published on Medium.

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