If you find yourself in a financial crunch, you have options to dig yourself out, such as borrowing from your emergency fund, a savings account or taking out a personal loan. You might also find yourself considering borrowing from your 401(k). While a 401(k) loan is often quick and typically cheaper than other types of credit, it could also end up jeopardizing your retirement.
Aaron Cirksena, founder and CEO of MDRN Capital, warns that when considering taking out a 401(k) loan, you may think you have no other option or if the interest rate is low, but generally, it does more harm than good.
“You're pulling money out of an account that’s supposed to grow for your future," he said. "That means you’re sacrificing the investment gains you could’ve had...and if you were to lose your job or switch jobs, the consequences of having to pay it back sooner than expected could leave you in a worse spot than before.”
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What is a 401(k) loan?
A 401(k) loan allows you to borrow money from your own employer-sponsored 401(k) retirement account. As a general rule, you can use the loan for any purpose, such as covering medical expenses or paying off debt. The loan must be paid back, with interest, over time and your plan administrator sets the terms. Essentially, you are borrowing from yourself and paying yourself back with interest. Depending on your employer's plan, you could take out as much as 50% of your vested account balance or $50,000, whichever is less, according to the IRS, unless 50% of the vested balance is less than $10,000. In that case, you can borrow up to $10,000.
"One important factor to consider is the interest rate,” says Jackie Reeves, Director of Retirement Plan Services with Bryn Mawr Trust. “Even though you’re technically paying interest back to yourself, assessing whether this makes economic sense in the long run is wise.” She goes on to say that since a loan is not a withdrawal, you would not face income tax or the 10% early withdrawal penalty, provided you repay the loan as agreed.
“However, one drawback is that borrowing from your 401(k) reduces the compounded growth potential of your retirement savings until the loan is fully repaid. This means your retirement balance may grow more slowly due to the missing investment gains while the loan amount is out of the market."
In most cases, you must pay back the amount you borrow from your 401(k) within five years of taking out the loan — the longest repayment period the government allows. This includes any interest paid out. Your plan may also set the number of loans you can take out or have outstanding at any one time. Some plans allow you to contribute to your 401(k) while repaying the loan, others don't .
Most 401(k) employer-sponsored plans allow automatic repayments through payroll deductions. Putting your payments on autopilot keeps your loan current. However, it also means your paycheck will be less until the loan and interest are paid off. And, although traditional 401(k) contributions are tax-deferred, there is no tax break on your loan repayments with a 401(k) loan. Instead, the money is taxed before it is deposited into your 401(k) and taxed again when you take the money out in retirement.
Not sure you’re ready to tap into your 401(k)? Take a look at the pros and cons before you decide.
Pros of a 401(k) loan
- With a 401(k) loan, you don't have to pay taxes and penalties like with hardship withdrawals that are taxed as ordinary income and come with a 10% early withdrawal penalty. Plus, any interest you pay on the loan goes right back into your 401(k) account. One exception is if you default on your loan. If that happens, you’ll pay a penalty and taxes if you’re under the age of 59½.
- If you miss a payment or default on your 401(k) loan, it won't impact your credit score. That’s because defaulted loans are not typically reported to credit bureaus.
- Since you’re essentially borrowing from yourself, the application process is quick and easy, unlike applying for a traditional loan. However, if you’re married, some plans may require spousal approval.
- If you use the loan for something that improves your financial standing in the long run, it could be beneficial. For example, paying off credit cards or other high-interest debt, therefore reducing the amount of interest you owe to lenders.
Cons of a 401(k) loan
- Not all employee-sponsored plans allow 401(k) loans.
- Leave your current job, and you might have to repay your loan in full before exiting the door. If your plan doesn’t state a specific protocol for departing employees, you’re bound by IRS rules.
- Default on the loan, and you’ll owe both a 10% penalty and taxes on the outstanding balance if you're under 59½. You’ll also lose out on any potential growth in your tax-advantaged account.
- The IRS sets loan limits, so in most cases, you can only borrow up to 50% of your vested account balance or $50,000 —whichever is less.
- You aren’t protected by bankruptcy. If you file for bankruptcy, you’ll still have to repay your 401(k) loan or face taxes and early withdrawal penalties.
What's the differences between a 401(k) loan and a 401(k) withdrawal?
The biggest difference between a 401(k) loan and a 401(k) withdrawal is taxes. With a 401(k) loan, you’re essentially borrowing money from your 401(k), which you pay back over a period of time, plus interest. Since the money isn’t considered ordinary income, you won’t owe any taxes. But remember, if you leave your job, you must pay back the entire balance of your 401(k) loan by the next year’s tax filing deadline.
With a 401(k) withdrawal, the money is treated like ordinary income, which means you pay taxes on the money when it is withdrawn, along with an early withdrawal penalty. However, you're not required to pay back the money into your 401(k) — it’s yours to do with whatever you want.
Sometimes, you may qualify for a hardship withdrawal. If that’s the case, you can withdraw the money from your 401(k) without an early withdrawal penalty under special circumstances. However, you do still have to pay income taxes on the money you withdraw.
How common are 401(k) loans?
In 2023, 10% of participants borrowed from their plan assets via either a loan or hardship withdrawal, according to a recent Wharton Pension Research Council paper, Does 401(k) Loan Repayment Crowd Out Retirement Saving? Implications for Plan Design Similarly, over 40% of 401(k) participants took out at least one loan over a five-to-seven-year period. However, the Wharton paper, which looked at data from Vanguard 401(k) plans also showed that retirement plan contributions "are remarkably stable after loans and hardship withdrawals."
Changes under SECURE 2.0, including the emergency withdrawal provision, which allows participants to take penalty-free distributions of up to $1,000 per year, are likely to increase early withdrawals in coming years, per the report.
Even so, UNLV finance professor Daniel Chi invites plan participants to ask themselves why they have put money into the 401k plan in the first place. “Overwhelmingly, the answer is "to support my life during the retirement years." If that’s the case, will taking a loan from 401k jeopardize that long-term objective? Is the loan intended to solve a short-term problem or a long-term problem? If short-term, it is better to find alternative solutions? If long-term, what is the probability that the loan can be repaid? Something's got to give, right? The decision is ultimately about tradeoffs, and understanding the horizon of the tradeoff is essential in the decision-making process.”
The takeaway is that taking out a loan against your 410(k) retirement account is a personal decision to meet a personal need. Generally, experts agree borrowing from your retirement account is not wise as it eats into the funds set aside for retirement. In the end, however, if you need (the predominant word here is need) the funds, a 401(k) loan can be a lifesaver.
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