Do you need a lump sum of cash to make a big-ticket purchase, pay off debt, or cover an unexpected financial emergency? But maybe you have less than perfect credit and are having a tough time getting approved for a loan. Or you’ve been approved for a loan but the interest rate is a bit high. And there’s a possibility you prefer to steer clear of credit inquiries to preserve your credit rating.
Either way, you may be considering borrowing from your 401(k) to secure the cash you need.
How 401(k) Loans Work?
If you’re enrolled in a 401(k) retirement plan at your place of employment, you may be able to borrow against it by taking out a 401(k) loan. And this practice is fairly common as a large number of companies permit loans of this type, even if some of the funds employees tap into are from employer contributions.
Some benefits and drawbacks to consider:
Pros
Wondering if you should take out a 401(k) loan? It may be a smart move if you need cash because of the ease of access to funds. There’s no lengthy application, underwriting process, or loan origination fees, and you won’t have to provide documentation to substantiate your income. Plus, you’re free to use the loan proceeds however you see fit as there are no restrictions in place to stop you from doing so.
If your credit is in the trenches, no need to worry as your credit score won’t be a factor. Even better, interest rates are also generally lower than what you’d find with personal loan products. And if you’ve recently explored bad credit loans, you are probably well aware of the hefty interest rates that they carry.
And unlike traditional personal loans, any interest you pay on your 401(k) loan will be deposited into your nest egg. So while paying interest may be a nuisance, you’ll benefit on the back end.
Another major benefit of a 401(k) loan is that it beats taking an early distribution, which is subject to a 10 percent penalty and federal income tax. You’ll pay interest on the loan proceeds, but it will be substantially lower than what Uncle Sam would receive if you decided to take an early distribution.
Cons
The biggest drawback to taking out a 401(k) loan is the compounding interest you’ll forfeit by borrowing against your nest egg. And the lower the balance, the less you will earn on your money without exerting much effort.
And if you’re contributing less because a bulk of your disposable income is going towards loan repayment, you could be missing out on free money if your employer offers a match. That’s unless your employer allows you to continue making contributions while repaying the loan.
It’s also important to be mindful of tax implications with regards to loan payments. When you contribute to your 401(k), it’s on a pre-tax basis so your taxable income will be lower and you won’t owe Uncle Sam until you start taking distributions. But if you take out a loan, the interest portion of the loan payments are subject to taxation right away, which in essence means you’ll be subject to double-taxation on your retirement contributions.
How to Qualify for a 401(k) Loan
Although the qualification criteria for 401(k) loans are relatively lax, there are some important considerations to bear in mind.
Employment Status
For starters, you must be currently employed with the company that extended the 401(k) to you to qualify for a loan. Why so? When you leave, either voluntarily or by termination, the plan becomes inactive and you have the option to transfer it to an IRA or take a premature distribution (if you’re not 59 ½ years of age). But you cannot continue to make contributions or any other changes. Consequently, the funds are not accessible for a loan.
Loan Limit
The next important consideration is the total amount you can borrow. According to IRS.gov, the loan amount must be the lesser of:
- $50,000
- The greater of $10,000 or 50 percent of the account balance that is vested.
To illustrate, if your 401(k) has a vested account balance of $60,000, your loan amount is capped at $30,000. But if your account balance is $150,000 and the vested amount is $120,000, your loan will be limited to $50,000.
Loan Term
Your 401(k) loan term cannot exceed 5 years, per federal regulations. Looking to pay the loan back sooner and minimize interest? You can opt for a shorter loan term with higher monthly payments.
How to Repay the Loan
Fortunately, plan administrators make it easy to repay loan proceeds with automatic withdrawals from your earnings before the proceeds hit your bank account, so you won’t have to worry about defaulting on the loan.
The monthly payment is the same each month since the interest rate is fixed. And since credit is not taken into consideration when taking out a loan, the rate you receive will be based on the industry-wide prime rate.
What Happens If You Leave Your Job?
Before taking out a 401(k), you want to keep in mind the serious implications that could result if your employment is severed prior before the end of the repayment period.
From the date of your departure, you’ll have 60 days to pay the outstanding balance. This may not pose much of a problem if you’re nearing the end of the loan term or if you only borrowed a small amount and have gotten back on track since. But if you still owe a large sum, the thought of having to come up with a large amount of cash in such a short period can be stressful.
Fortunately, it’s not the end of the world if you can’t pay and the plan administrator won’t throw you to the wolves. Instead, they’ll recoup the outstanding balance from the funds that remain in your 401(k) and classify it as an early withdrawal. And in most instances, you’ll be subject to federal income tax and a 10 percent penalty. It’s an unpleasant financial blow but beats negative reporting to the credit bureaus and you can always recoup your losses by getting on track financially and increasing your contributions to subsequent retirement plans.
Viable Alternatives to a 401(k) Loan
Emergency Fund
If you do have an emergency on your hands, it may be a wiser move to dip into your stash than to borrow against your 401(k). You won’t have to pay interest and can work diligently to build the balance back up. But regardless of which choice you take, the reason for the withdrawal should be an “emergency” or major need, and not something you want just because.
Personal Loan from Relatives or Friends
This option may not come with interest and can be very convenient. However, you have to consider the long-term impact on the relationship if you’re unable to pay back what you promised promptly.
Home Equity Loan
Home equity loans can be used as a last resort if you’d prefer not to touch your nest egg. Why so? The loan terms and lengthy and the interest rates are competitive, giving a lower monthly payment. But since the loan is secured and uses your home at collateral, you could lose your place or residence in the event you are unable to make payments and the loan goes into default.
The Bottom Line
Ultimately, it’s up to you to decide if the benefits of borrowing against your 401(k) outweigh the cost. While you’ll be dipping into your nest egg and possibly pumping the brakes on retirement contributions for a bit, it may be a worthwhile maneuver to get back on track financially. And if you’re far away from retirement, there’s always time to play catch-up.
