You’re faithfully piling up money in the “lockbox” that’s your workplace retirement 401(k) savings plan. But something has come up, and you need money now. Can you pick that lock and get to your 401(k) money early by borrowing against it?
You probably can, but it may not be worth it.
The design of workplace 401(k) plans discourages account holders from easily accessing the money. After all, the entire point is to leave the account alone and let investment returns accumulate, building your future financial security.
Still, life happens — even to those who manage their money carefully. Here’s how to figure out if you should take a 401(k) loan, how to minimize financial fallout if you do and what alternatives are available.
What is a 401(k) loan?
A 401(k) account is a government-approved retirement plan run by your employer as one of the benefits it offers employees. Once you enroll, your employer puts part of your paycheck into the 401(k) account. Under the most common plans, your contribution isn’t taxed when you earn and save the money because it’s taxed after you retire and start withdrawing from your 401(k).
This can be beneficial because it allows the money you save in your 401(k) account to grow and compound tax-free. Plus, for each dollar you contribute to a 401(k), you reduce your taxable income by an equal amount for that contribution year.
A 401(k) loan is an amount you borrow from your 401(k) account. In essence, you are borrowing from your own savings — but because a 401(k) account is set up for long-term retirement security, such loans are covered by specific federal laws. Often, people borrow against their 401(k) accounts for home renovations, a major purchase such as a car, or to get them through a cash crunch, such as the gap between buying a house and selling their prior house.
Steady savings are a cornerstone of lifelong financial stability — so important, in fact, that retirement accounts are deliberately structured to make it hard to borrow against that money or take it out early.
Your first step is to read the fine print that describes the terms of your plan. Find out if and how it allows loans. Usually, the plan details are available in print or digitally through your employer’s human resources benefits portal, intranet or app.
Not all 401(k) plans are identical. The IRS describes each type of plan, so you can be sure you know the rules of the plan you’re in.
And not all 401(k) plans allow loans. If your plan doesn’t allow loans, scroll down to the section of this article headlined “What alternatives are there to 401(k) loans” to learn about other options for getting cash if you’re in a pinch.
Chances are you will find that your plan allows you to borrow against your 401(k) savings, as most do.
How do 401(k) loans work?
The standard way to borrow against your 401(k) plan is simple.
First, contact the plan administrator, which might be someone in the human resources department at your company or an outside firm that handles retirement and other benefits for your employer.
Then, request the forms to take out a loan against your 401(k). Because you have already reviewed the details of your specific plan, you know what’s allowed and what isn’t.
The IRS rules for a 401(k) loan spell out the basics:
- The most you can borrow is 50% of your vested balance, or $50,000, whichever is less.
- If your vested amount is less than $10,000, you can borrow up to $10,000.
- You’ll have to repay your loan to yourself within five years.
- Payments must be made at least quarterly.
- If the purpose of your loan is a down payment to buy the house that you will live in, you might be granted exceptions to the five-year repayment schedule.
- Generally, you don’t have to go through a credit check because you are borrowing money from yourself.
- Depending on the specifications of your employer’s 401(k) plan, you might or might not have to pay a processing fee to cover the cost of the loan paperwork.
- Loan payments will be deducted from your paycheck.
Most financial planners will tell you it’s pretty simple — until life gets complicated.
Risks of taking out a 401(k) loan
Job stability is one of the biggest tripwires. If you change jobs — by choice or not — before you are done paying back the 401(k) loan, you may have to pay off the entire loan in short order.
“A really important factor to consider is, are you planning on leaving your job or are you nervous about layoffs,” said Lisa Tuttle, a financial advisor based in Edina, Minnesota. “If you leave your job, or are no longer employed with that company, you will be forced to pay the full balance of the loan back, and if you can’t do that, whatever you can’t pay back, you’ll be subject to the taxes because it will count as an early distribution plus a 10% penalty.”
But one of the biggest drawbacks to borrowing against your 401(k) is that there’s no way to know beforehand how much more you could be earning in that account through investments.
“If I take out a 401(k) loan, and if the market is up in that five-year repayment schedule, all of this time I’ve been paying back my loan instead of putting money in the 401(k), I’m missing out on growth from the stock market,” said Tuttle.
She added, “A common thought is, ‘It’s a free loan,’ but as you are paying it back, you’re putting (paycheck contributions) that would normally go to your retirement savings (instead) to pay back that loan.”
In other words, while you’re paying off the loan, you might be losing out on potential investment gains, and that might put you behind on your long-term financial goals.
If the market goes down, you might come out slightly ahead by paying yourself back with interest. “That’s the net cost, and there’s no way of knowing what that is,” said Tuttle. “There are a lot of variables that are unknown when you take out a 401(k) loan, whether it’s staying employed or what happens to interest rates and the stock market. It all affects the net impact.”
Advantages of borrowing from a 401(k)
You’ll know the interest rate of the loan when you take it out, so you can compare it to going rates for other types of consumer loans, such as maintaining a balance on your credit card, getting a bridge loan to buy one house before your current house is sold, opening a home equity line of credit, or taking out a loan to buy a car.
When interest rates are high, you’ll at least be paying yourself back at a close-to-market rate, so all is not lost, said Tuttle and other financial advisors.
If you can pay back the loan while continuing with your regularly scheduled 401(k) contributions — especially to capture the match from your employer — you likely can catch up and minimize the impact on your retirement plan, said Tuttle and other advisors. That is, borrowing from your 401(k) and consistently paying it back may be better than taking out a high-cost personal or credit card loan.
Should you use a 401(k) loan to pay off debt?
The years right before retirement can throw financial curveballs, and that’s when borrowing against your 401(k) can be both tempting and tricky, said Eric Szczurowski, managing partner of Hauppauge, New York-based Kuttin Wealth Management.
In some limited circ*mstances, a 401(k) loan can be an invaluable tool to close very short-term gaps, especially when selling one house and transitioning to a smaller house or retirement community. But don’t attempt any fancy 401(k) footwork without first consulting with your tax advisor, he warned.
The danger with borrowing from yourself, in any form, is that it’s too easy to get into the habit of doing so, said Szczurowski and Tuttle. It may make sense to pay off a high-interest-rate credit card with a moderate-interest-rate 401(k) loan, but only if you subsequently keep a lid on credit card spending and balances.
What alternatives are there to 401(k) loans?
Borrowing against your future financial stability “should always be a last resort,” said Szczurowski.
If you’re tempted to keep dipping into that supposedly off-limits pot of money, there may be an underlying cash flow issue, he said. It’s an indicator that you need to figure out how to keep those little financial fires from igniting and how to access a financial fire extinguisher.
The first line of defense against urgent borrowing is having an emergency fund, Szczurowski and Tuttle said. A cushion of even $1,500 can put a firewall between routine crises — replacing a refrigerator, fixing the car or covering the cost of funeral travel — and your long-term financial security.
Very short-term loans, such as personal loans and maintaining balances on credit cards, always come at a high cost and should be taken out only when you have a realistic plan to pay off those loans as soon as possible, Szczurowski and Tuttle said.
Frequently asked questions (FAQs)
Yes. You have two options: pay more each month, or pay off the whole balance at once and close the loan. To pay more each month, connect with your plan administrator and update the paperwork that deducts the payments from your earnings with the new amount you want to repay monthly.
Or, say you snag a nice bonus and want to pay yourself back first. Back you go to the plan administrator with the final and full payment. Be sure to document the loan payoff, just in case there’s a glitch in the system. When you receive your next 401(k) statement, be sure to confirm that the loan is paid off and your account is restored.
Yes. Because 401(k) plans are administered by your employer, and because you repay the loan through paycheck deduction, the entire process is channeled through your employer. If you lose or change your job, you must pay off the 401(k) loan immediately.
