401(k) Loans: How To Borrow Money From Your Retirement Savings
Andrew Dehan6-Minute Read
August 17, 2022
If you need financial assistance in the form of a loan, you have many options to choose from, including a 401(k) loan. Those with an established 401(k) retirement account may be eligible to take advantage of this loan if their employer offers it, but borrowers should be aware of certain conditions and terms.
Let’s break down the basics of borrowing a 401(k) loan, the risks involved and alternative options that may be available to you.
How Does A 401(k) Loan Work?
If you have a 401(k) retirement plan, you may be eligible to borrow against it with a 401(k) loan, which uses the savings from your retirement account. The amount you can borrow is dependent on your employer, but you may be eligible to take out upward of 50% (or up to $50,000) of your savings within a 12-month period.
A 401(k) loan is different from a withdrawal, which permanently removes the money you take out of your retirement savings. You can use money from a withdrawal immediately, although you’ll incur taxes and fees for this service. With a 401(k) loan, you’re essentially borrowing the money from yourself and paying it back over time. The payments and interest charges that you make on this loan will go back into your account.
Repaying A 401(k) Loan
In general, you have up to 5 years to repay a 401(k) loan. This term is eligible for extension if you’re using the funds to buy a home for your primary residence. The Internal Revenue Service (IRS) requires that loans be repaid on a quarterly basis, which includes principal and interest on the balance of the loan. These repayments are not considered employee contributions to your 401(k) plan.
Failure To Repay The Loan
If you miss the repayment deadline, your remaining balance will be taxed at the income tax rate and treated as income. Once the deadline for repayment is missed, your employer will file Form 1099-R with the IRS.
What If You Leave Your Job?
Because these plans are employer-sponsored, you could be required to pay back your loan in full if you leave your job, or get terminated or laid off. Most retirement plan sponsors will require you to pay the loan back in full at the end of your employment contract. If you’re unable to do so, you’ll likely have to pay hefty taxes and penalties. The balance is also treated as if you’ve defaulted on the loan, and it’s labeled a “deemed distribution.” You can avoid paying these penalties if you can repay your loan in full before the next year’s tax return deadline.
Should You Borrow A Loan From Your 401(k)?
Although a 401(k) loan may sound attractive, risks are involved with borrowing from your retirement savings. The biggest risk factor is that doing so will decrease the amount available to you when you retire, especially if you’re unable to replenish your account over time. Even after you fully pay back the loan, this money still has less time to fully mature.
Also, if you can’t repay the loan on time, your loan will be treated as a hardship withdrawal. You will be charged a 10% early withdrawal penalty fee on the balance if you’re under the age threshold of 59½, or if you’re younger than 55 and retired. Before taking out a 401(k) loan, it’s best to consider the implications this could have on your future.
Pros And Cons Of A 401(k) Loan
Let’s dive into a few of the pros and cons of taking out a 401(k) loan.
- The approval process is easy. If your employer’s plan allows you to borrow against your 401(k), acquiring this loan should be relatively easy because there’s no lender approval process or credit check required like with other types of loans.
- The interest payments are made to you. Because you’re making payments back to yourself on the principal and interest of the loan, that interest goes directly into your retirement account rather than to a lender.
- The interest rates may be low. Depending on the lender, 401(k) loans may have lower interest rates for borrowers with strong credit scores.
- You’ll have lower loan limits. 401(k) loans are limited to 50% or $50,000 (whichever is less) of your vested account balance. Depending on how much you need, this contribution limit may not be enough to cover your debts or expenses.
- Future retirement plan implications are possible. When you borrow from your 401(k), even if you intend to replace it, you lose the gains you had made over the life of the account, which could be difficult to recoup.
- Fees are involved. With 401(k) loans, most plan providers will require you to pay fees for this service. If these fees are significant, it could make it less worthwhile to obtain a 401(k) loan that already has a low lending limit.
- You’re required to be employed. To acquire a 401(k) loan, you’ll need to be employed. This can force many borrowers to feel trapped at their current place of employment until their balance is paid off. If you are fired or let go, then you may be forced to repay the loan sooner than expected or face taxes and penalties.
FAQs About 401(k) Loans
Will my employer know if I take a 401(k) loan?
Yes, considering you’d be borrowing from a company-sponsored plan, and you’ll typically have to go through human resources (HR) when requesting the loan and repay it through payroll deductions. If you wish to keep your borrowing confidential from some people within your company, you should speak directly with your HR representative.
What’s the average 401(k) loan interest rate?
The interest rate on your 401(k) loan will typically depend on your particular retirement plan and the current prime rate. The average annual percentage rate (APR) on 401(k) loans is 1% above the current prime rate.
Does a 401(k) loan hurt me?
Taking out a 401(k) loan can negatively affect your future finances because it prevents you from making contributions to your account or taking advantage of employer-matching contributions for the life of the loan, which could last 5 years. Additionally, the interest you earn on the loan may be less than if you’d just kept the money in your account.
Can I borrow from my 401(k) without penalty?
Borrowing a 401(k) loan is different from making an early withdrawal from your account, so you won’t typically face penalties unless you can’t repay the loan or you change employers. 401(k) loans typically don’t have prepayment penalties either.
How has COVID-19 Affected Borrowing A 401(k) loan?
Starting in 2020, the CARES Act doubled 401(k) loan limits to 100% – or up to $100,000 – of a qualifying individual’s account. The 10% penalty fee for early withdrawals was also waived for eligible participants.
Final Thoughts: Is A 401(k) Loan Or A Personal Loan Right For You?
With a 401(k) loan, it’s important that you research and understand the terms, conditions and requirements before making a decision. You should also ask yourself what the future implications could be if you decide to borrow from your hard-earned retirement savings.
If you're considering alternative options like a personal loan, apply online today and see what rates you qualify for.
*Same day funding is available for clients completing the loan process and signing the Promissory Note by 1:00 p.m. ET on a business day. Also note, the ACH credit will be submitted to your bank the same business day. This may result in same day funding, but results may vary, and your bank may have rules that limit our ability to credit your account. We are not responsible for delays that may occur due to an incorrect routing number, an incorrect account number or errors of your financial institution.
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