How a 401(k) loan works

Many 401(k) retirement plans allow you to borrow up to $50,000 or half of your balance tax-free, whichever is less. If your balance is below $10,000, you're allowed to borrow the full amount.

For example, if you have a $60,000 balance, you could borrow $30,000 — the lesser of 50% of your balance and $50,000. If your 401(k) balance is $150,000, you could only access $50,000.

Keep in mind, these numbers refer to your “vested” balance. Funds contributed by your employer may not be fully accessible to you — that is, vested — for a period of time, depending on your plan.

These withdrawals are commonly called 401(k) loans, but since there is no lender involved, they’re technically not loans. Rather, it’s a strategy to tap into a chunk of your retirement savings tax-free before you reach retirement age.

While your plan may require you to pay “interest,” all of that extra money just goes back into your own retirement account. The aim is simply to return your account balance to the state it would have been in had you not withdrawn the money and instead allowed your balance to grow.

No credit check is required, though you may have to pay a modest origination or administrative fee. You typically have to repay your “loan” within five years, making scheduled payments at least every quarter. There are some exceptions, like if you use the money to buy a new primary residence.

If you fail to replace the money you withdrew, the IRS treats your withdrawal as a normal distribution and smacks you with hefty penalties. You’ll have to pay income tax on the loan, plus a 10% early distribution tax if you’re under age 59 ½.

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Borrowing from 401(k) pros and cons

Before you borrow from your 401(k), it’s important to understand all the advantages and disadvantages compared to other kinds of loans.

Pros

  • Fast financing. It can take between a day and several weeks to receive your money. This depends on your plan and company, but online requests are often speedy.
  • Convenient. No need for loan shopping, proving your creditworthiness or hassling with lenders.
  • Flexible. Repayment terms are often flexible as long as you make your minimum quarterly payments and repay everything within five years.
  • Low interest. Even if you think of it like traditional interest, you’ll pay less than higher-cost borrowing alternatives like credit cards, payday loans and even many personal loans if you don’t have superb credit.
  • Potential savings boost. When you borrow from a 401(k), you are actually liquidating some of your investments. If the market is trending downward, you may actually come out ahead when you buy back in.

Cons

  • Less compounding. You lose the power of tax-free compounding on the money you borrow for the length of time that you borrow it. Also, some plans may not let you contribute new money for a certain period, including employer-matched contributions.
  • Tax inefficiencies. Normal 401(k) contributions are tax-deferred, but the “interest” portions of your 401(k) loan repayments are made with after-tax dollars. You will, in effect, be taxed twice on that money.
  • Risk of missing deadlines. If life throws a curveball and you can’t repay your loan on time, you’ll pay extra taxes and shrink your nest egg.
  • Stuck with your job. If you leave your employer for any reason — even unwillingly — you will have to repay your loan before your tax return for the current year is due.

To determine if a 401(k) makes sense, you have to consider all the opportunity costs.

When a 401(k) loan is smart (and when it’s not)

Taking advantage of a 401(k) loan can make sense when you need emergency short-term cash and don’t have better liquid options.

You have five years to pay it back, but it’s safer to take a smaller loan that you’re able to pay back within a year or less. That way you won’t miss as much time in the market, and you’re less likely to encroach on the five-year cutoff.

For example, borrowing from your 401(k) could make sense to pay off a hefty balance on a high-interest credit card, assuming you can repay the money quickly.

This is especially true in a down market when your 401(k) isn’t growing much anyway. Generally speaking, it’s not a good idea to time the market. But if you’re in the middle of a recession with no end in sight, you could theoretically borrow from and repay your 401(k) before the market bounces back.

But even if the market is down, it doesn’t give you a free pass to borrow for the wrong reasons.

Treating your 401(k) like a checking account will not only put your retirement savings at risk if you miss a deadline, but you’ll miss out on compound earnings, get double taxed on your interest and potentially lose employer contributions.

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About the Author

Mitchell Glass

Mitchell Glass

Freelance Contributor

Mitchell is a freelance contributor to MoneyWise.com.

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