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If you need cash, borrowing from your 401(k) can be a low-interest way to quickly get your hands on some money.
Provided your 401(k) plan permits loans, borrowing from your 401(k) may help you pay bills, fund a big purchase or make a down payment on a home.
But you’ll need to pay interest if you want to tap your retirement account. How much you can borrow right now may depend on whether you’ve been affected by the COVID-19 pandemic (you may be eligible to borrow more money than typically allowed).
We’ll review how 401(k) loans and repayment works, as well as the temporary rules implemented by the Coronavirus Aid, Relief and Economic Security Act, or CARES Act.
- What is a 401(k) loan?
- How much can you borrow?
- How long do you have to repay a 401(k) loan?
- Why do people get 401(k) loans?
- What happens if you leave your job?
- What could be the cost of missed retirement savings?
- What are some alternatives to a 401(k) loan?
1. What is a 401(k) loan?
If your employer provides a 401(k) retirement savings plan, it may choose to allow participants to borrow against their accounts — although not every plan will let you do so. Borrowing from your own 401(k) doesn’t require a credit check, so it shouldn’t affect your credit.
As long as you have a vested account balance in your 401(k), and if your plan permits loans, you can likely be allowed to borrow against it. Just like with any other loan, you’ll need to repay a loan from your 401(k) with interest within a set time frame.
2. How much can you borrow?
Plans can set their own limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
But the CARES Act provides some exceptions to that limit. The law allows those who qualify to borrow up to $100,000 (minus any outstanding 401(k) loans from your plan) or 100% of your vested account balance, whichever is less. That provision expires on Sept. 22, 2020.
To qualify, you likely need to fall within at least one of several scenarios, including …
- You, your spouse or a dependent is diagnosed with COVID-19
- You experience financial hardship as a result of being quarantined, furloughed or laid off, or your hours are reduced because of COVID-19
- You can’t work and are experiencing financial hardship because the COVID-19 crisis has cut off your access to childcare
- You have financial troubles because a business you operate or work for closes or reduces its hours as a result of COVID-19
3. How long do you have to repay a 401(k) loan?
Generally, you have up to five years to repay a 401(k) loan, although the term may be longer if you’re using the money to buy your principal residence. IRS guidance says that loans should be repaid in “substantially equal payments that include principal and interest and that are paid at least quarterly.” Your plan may also allow you to repay your loan through payroll deductions.
The CARES Act allows plan sponsors to provide qualified borrowers with up to an additional year to pay off their 401(k) loans.
The interest rate you’ll pay on the loan is typically determined by the plan administrator based on the current prime rate, but it — and the repayment schedule — should be similar to what you might expect to receive from a bank loan. Also, the interest isn’t paid to a lender — since you’re borrowing your own money, the interest you pay is added to your own 401(k) account.
4. Why do people get 401(k) loans?
As long as a plan allows it, participants generally can borrow from their 401(k) for any reason. Some plans may only allow loans for specific reasons, so be sure to check your plan’s rules before trying to borrow.
Since you’re borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401(k) loan as long as you meet the plan’s requirements for borrowing. In some cases, a requirement may be getting approval from your spouse (if you’re married), because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401(k) loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Covering medical expenses
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesn’t mean 401(k) loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
5. What happens if you leave your job?
When you take out a loan from a 401(k), you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401(k) loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. That means if you left your job in January 2020, you would have until April 15, 2021 (assuming no extensions) — when your 2020 federal tax return is due — to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.Learn more: Tax reform gives some 401(k) borrowers more time to repay
If you can’t repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if you’re younger than 59½ or don’t otherwise qualify for an exemption.
Unfortunately, this worst-case scenario isn’t rare. A 2014 study from the Pension Research Council at the Wharton School of the University of Pennsylvania found that 86% of workers in the sample who left their jobs with a loan outstanding eventually defaulted on the loan.
6. What could be the cost of missed retirement savings?
A report from the National Institute on Retirement Security found that 95% of millennials aren’t saving enough for retirement. And a 2017 study from Wells Fargo shows that other generations aren’t faring much better. So if you’ve been trying to beat the odds and put aside adequate savings for retirement, taking out a 401(k) loan can be a triple whammy.
First, some plans don’t allow participants to make plan contributions while they have an outstanding loan. If it takes five years for you to repay your loan, that could mean five years without adding to your 401(k) account. During that time, you may be failing to grow your nest egg and you’ll miss out on the tax benefits of contributing to a 401(k).
Next, if your employer offers matching contributions, you’ll miss out those during any years you aren’t contributing to the plan. Loan repayments aren’t considered contributions, so if the employer contribution is dependent upon your participation in the plan, you may be out of luck if you can’t make contributions while you repay the loan.
And finally, your account will miss out on investment returns on the money you’ve borrowed. Although you do earn interest on the loan, in a low-interest-rate environment you could potentially earn a much better rate of return if the money was invested in your 401(k).
7. What are some alternatives to a 401(k) loan?
When cash is tight, borrowing from your 401(k) plan and paying yourself interest may seem like a good idea. But before you borrow, weigh all your options. Here are a few.
- Consider a home equity loan. If you have equity in your home, a home equity loan may allow you to tap your home’s equity to qualify for a loan. This may be a good option when you need the loan funds for home repairs and improvements, as the interest on a home equity loan could be tax deductible.
- Consider a taxable withdrawal. If you need cash because of a financial hardship, consider a hardship withdrawal rather than a loan (what is considered a hardship withdrawal varies by plan). You’ll likely have to pay income taxes on the distribution, but you may qualify for an exception that allows you to avoid a 10% early-withdrawal penalty. There are disadvantages to hardship withdrawals, too, so make sure to do your research first. If your distribution is related to financial hardship from coronavirus, you may also be eligible to have the 10% penalty waived.
- Consider a personal loan. If your credit is good, you may be able to qualify for a personal loan with favorable terms. You can use the funds from a personal loan to pay for virtually anything. And since they’re typically unsecured, you don’t need to risk collateral to secure the loan.
A 401(k) loan may be a way to get cash when you need it. But it’s not the only option, and you should explore all possibilities before deciding what type of loan to pursue.
If borrowing from your 401(k) is your only option for accessing necessary cash, make sure you understand all the terms. It’s also important to have a plan for how you’ll repay the loan.
Look for opportunities to pay off your 401(k) loan ahead of schedule by making extra payments when you can — for example, if you have a sudden financial windfall or receive a raise. The sooner you can pay off the loan, the faster you can get back to generating returns on your investment and the less you’ll have to worry about defaulting on the loan or facing a big tax bill if you leave your job.