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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 funds.
Provided your 401(k) plan permits loans, borrowing from your 401(k) can help you fund a big purchase, and you may even be able to use the money as down payment on a home. But a 401(k) loan is by no means “free money.”
You’ll need to pay interest. And repaying the loan could trip you up, especially if you leave your job before you’ve paid back the loan in full. Here are some things to know about repaying your 401(k) loan.
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.
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 borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
For example, if your vested account balance is $11,000, you can borrow $10,000 of it, because 50% of your balance would be just $5,500. If you have $30,000 vested in your account, you could borrow half that amount — $15,000. But if your 401(k) has a vested balance of $150,000, the maximum you could borrow from it would be $50,000, even though 50% of your vested account balance is $75,000.
How long do you have to repay a loan from a 401(k)?
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 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 is not paid to a lender. Since you’re borrowing your own money, the interest you pay is added to your own 401(k) account.
Why do people take 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 are married), because your spouse may be entitled to half of your retirement assets if you divorce.
Uses for 401(k) loan proceeds may include …
- 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.
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 a 401(k) loan can be a triple whammy.
First, some plans do not allow participants to make plan contributions while they have a loan outstanding. 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, 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 are not 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).
Leaving your job
When you take 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 2018, you would have until April 15, 2019 (assuming no extensions) — when your 2018 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 are 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.
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 proceeds 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 will 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.
- 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 loan from your 401(k) may be an easy 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, such as 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 should you leave your job.