4 Reasons to Take Out a 401(K) Loan
As inflation rises, you may be finding it tough to meet your monthly expenses. A recent survey found that 54% of Americans are dipping into their savings to make ends meet. Some are looking at their 401(k) balances and wondering if they can tap into their retirement savings to manage rising costs.
While you can withdraw funds from your 401(k) directly in whatever increments you choose, taking that route can result in penalties for early withdrawal. You also lose the tax benefits on any money withdrawn. So direct withdrawal may add to your already-rising expenses.
Fortunately, your 401(k) comes with a benefit that other retirement accounts don’t — the 401(k) loan. While this option gets a bad rap at times, it can be beneficial in the long run if you do it correctly.
Read on to learn the four main reasons to take out a 401(k) loan and the rules and regulations involved so you can decide if it’s the best option for you.
What is a 401(k) loan?
A 401(k) is a tax-advantaged account set up by your employer to help you save for retirement. You make pre-tax contributions to your account to lower your taxable income in the present. In return, your money grows tax-free, and any earnings you make are reinvested, allowing you to grow your assets through compounding.
When you are 55 and retired, or age 59 ½, you can withdraw the money with no penalties, but you'll need to pay taxes on the withdrawn amount. So think of your 401(k) as a savings account that you can’t touch without penalty.
A situation may arise where you need money, but getting a traditional loan isn’t feasible. In that case, you may be able to take out a loan against your 401(k), which you’ll pay back with interest just like a normal loan — but you’d be borrowing from yourself.
401(k) loans are appealing because they are quick and convenient. Since you’re borrowing from yourself, there’s no credit check and no application. You and your plan administrator will figure out your payment options, which may include payroll deductions.
Just like a traditional loan, you’ll pay interest, but the 401(k) loan interest rate may be slightly better than what’s offered by a bank. The advantage of a 401(k) loan is that you are paying that interest to yourself rather than a bank. So, in a way, that money isn’t lost.
To keep your retirement plan on track while you're paying back the loan, continue to make regular 401(k) contributions, especially if your employer offers a contribution match. Some 401(k) plans may limit employer contributions — or even your contribution — for the course of the loan.
The parameters of every 401(k) are different. Some may need spousal approval for loans, while others don’t. Others may only offer loans in specific situations, while some may not allow 401(k) loans at all.
There are very specific rules and regulations associated with 401(k) loans, and if you violate them, you can face steep penalties.
4 common reasons to take out a 401(k) loan
Loans from your 401(k) are best for situations where you face a serious one-time demand, such as a medical bill that wasn’t covered by insurance or a lump sum cash payment on something like high-interest credit card debt.
Some 401(k) plans have very specific guidelines about when an account owner can take out a 401(k) loan, so check with your plan administrator before you begin the loan process.
1. Putting money down on a house
One of the biggest hurdles to buying your first home is coming up with a down payment. Most mortgage loans require 20% down, and with the rise in home prices, that can be out of reach for many people. While first-time homebuyer loans allow you to put down a significantly smaller down payment, you’ll have to pay extra fees like private mortgage insurance (PMI).
If you want to put down 20% on a mortgage loan to avoid PMI, you can finance it with a 401(k) loan. You can also take out a 401(k) loan to cover closing fees or the costs to renovate or repair your existing home (as long as it's your primary residence).
While you need to pay most 401(k) loans back within five years, you may be able to negotiate a longer repayment schedule when using 401(k) loans to buy a home. Be aware that financing your entire home purchase through your 401(k) comes with significant drawbacks since you won’t be able to write off the interest on your taxes like you could with a mortgage loan.
2. Paying back a debt owed to the IRS
If you owe the IRS for unpaid or underpaid taxes, you may face levies against your wages and bank accounts or a tax lien on your home.
It’s best to pay off any debt to the IRS immediately to avoid those situations. A 401(k) loan can help you avoid problems with the IRS. In this instance, before you pay back the full amount you owe the IRS, ask for an offer in compromise, which allows you to settle your tax debt for less than the full amount you owe so you can borrow less from your 401(k).
3. Paying for medical expenses
For many Americans, having health insurance may not be enough to cover all medical expenses. If you experience a medical emergency and are faced with unexpected medical bills not covered by your insurance — and you lack the funds in your health savings account (HSA) to cover them — you can take a loan from your 401(k) to pay them.
4. Covering education expenses
If you or your dependents are enrolled in college, you may be able to take out a 401(k) loan to cover tuition and other associated costs. Since your interest payments will be paid to your 401(k) account rather than a bank, it may be a better choice than taking out a student loan.
The 401(k) loan rules
Since 401(k) accounts are created and managed by employers, the rules and regulations associated with them vary widely. If you are considering a 401(k) loan, ask your plan administrator for the guidelines of your specific account.
However, most 401(k) loans abide by the following rules:
You can only borrow a maximum of $50,000 or 50% of your investment, whichever is less
You don't have access to the entire vested account balance of your 401(k) for a loan. If you aren’t sure how much you have in your account, check your latest 401(k) statement. The IRS limits the maximum you can borrow to $50,000 or 50% of your investment, whichever is smaller, over 12 months. Some plans may even include a minimum loan you must take out.
For example, if you have $30,000 in your 401(k), you would be allowed to take out a loan for $15,000, which is 50% of the investment. If you had $200,000 in your account, you would be able to borrow a maximum of $50,000.
Your plan may allow you to take out several 401(k) loans that add up to the maximum amount, while others may only allow you to take out one loan at a time.
In most cases, you must repay your 401(K) loan within 5 years
Most 401(k) loans must be repaid within five years. There are two exceptions:
- 401(k) loans to finance your primary residence often have 25-year payoff periods.
- If you leave your job, you'll have to repay the entire loan by the tax filing date of the following year. For example, if you leave your job in May 2023, you'll have until April 2024 to pay back the balance of the loan.
If you don't pay back the loan within the time stipulated in the loan’s terms, the loan will be treated as a withdrawal, and you'll be liable for income tax plus a 10% penalty for early withdrawal. Fortunately, a 401(k) loan default won't affect your credit score.
You must make payments at least quarterly
The IRS requires you to make your 401(k) loan repayments at least quarterly. To help you stay on track, your plan administrator will map out your payment plan in the loan terms. You can decide to make payments with each paycheck through payroll deductions or you can opt to pay it back in quarterly installments.
Missed payments won't affect your credit score since you’ve borrowed from yourself and not a bank.
What's the difference between a 401(k) loan and an early withdrawal?
401(k) loans are usually only offered to current employees, so if you have left your job, you might not be able to take out a loan. But you could do an early withdrawal to get access to your savings instead.
Early withdrawals should be used as a last resort. By taking out money from your account with no intention of paying it back, you'll have to pay taxes and a 10% early withdrawal fee. The withdrawal will also cost you any future earnings you could have made if you'd left that amount in your account untouched.
If you don’t think you’ll be able to pay off the loan, but you need the money, you may qualify for a hardship withdrawal. While you’ll still have to pay taxes on the amount, you may not have to pay the early withdrawal penalty.
The IRS requires you to show “immediate and heavy financial need” to qualify for a hardship withdrawal. The following situations may qualify:
- Avoiding foreclosure on your primary residence
- Avoiding eviction from your rental property
- Financing unexpected medical bills
- Covering the cost of tuition for you or a dependent
- Paying for a funeral and other burial-related expenses
- Financing repair or purchase costs for a primary residence
Unlike a 401(k) loan, a hardship withdrawal will require you to divulge the exact reason you need a loan, and you'll only be allowed to withdraw the amount you need. Your plan provider will also need to verify how you use the funds you withdraw. If they find you used the funds for other reasons, you'll have to pay the 10% early withdrawal penalty.
What happens to a 401(k) after ending employment?
If you leave your job, you have several options for how to handle your 401(k):
- Cash it out — but you’ll pay taxes and early withdrawal penalties on your full 401(K) balance
- Roll it over to the 401(k) offered by your new employer
- Roll it over to a traditional or Roth IRA
- Keep it where it is — although you may lose the ability to access certain features, like taking a loan from your 401(k)
If you took out a 401(k) loan and your employment ends, you’ll need to repay the full amount of the loan by the next tax filing deadline.
Alternative options for borrowing a 401(k) loan
Because taking out a 401(k) loan can inhibit your ability to grow your retirement fund for the duration of the loan — and you’ll face stiff penalties if you can’t repay the loan on time — financial professionals recommend you seek other financing options first. Below are some of the most common alternatives.
Ask family and friends for help
If you have a short-term need for cash, see if a friend or family member can help you cover the costs. You’ll be able to avoid the credit check involved with a traditional loan, and they may be more flexible on repayment terms than a traditional lender.
Use your savings
Examine your savings and see where you can pull out some cash. That’s what an emergency fund is for. Consider all the following:
- HSA savings for medical expenses
- Checking accounts
- Savings accounts
- Other brokerage accounts
Opt for a personal loan
Personal loans are usually considered unsecured, which means you won’t be required to put up any collateral. Explore our list of the best personal loans to find your best option.
If you can’t get a personal loan, you may be able to get a home equity line of credit (HELOC), which has the added benefit of potentially tax-deductible interest.
Is tapping into your retirement savings the right move?
When deciding whether or not to take out a 401(k) loan, focus on the long-term benefits rather than the short-term influx of cash. For example, it might save you money in the long run if you take out a loan to pay off high-interest credit card debt.
Taking out a 401(k) loan isn’t necessarily a habit you want to get into, but it may be a practical choice in the right situation. To ensure you’re making the right borrowing decision, ask for help from a financial professional. An experienced advisor is in a better position to see your total financial picture and crunch the numbers for you.