Rising costs due to record inflation are stretching many families’ budgets to the breaking point. Sadly, many are looking to fill budget shortfalls by tapping their retirement plans. Hoping to avoid taxes and penalties on early withdrawals, owners of 401(k) plans are choosing to borrow the funds they need. While borrowing from a 401(k) plan (borrowing is also allowed in 403(b) plans) can be helpful, it’s not always the best solution. It would be essential to understand how 401(k) loans work and their drawbacks before deciding whether to take out a loan.
The Basics of 401(k) Loans
Most 401(k) plans include a borrowing provision, allowing plan participants to access a portion of their funds via a loan. Though employer plans vary, many allow you to borrow up to 50% of the value of your account up to $50,000. The borrowed funds can be used for any purpose and must be repaid within five years, though the repayment term can be extended to 25 years if using the loan to buy a principal home, and there is no prepayment penalty for paying the loan off early.
The interest rate on many 401(k) loans is pegged to the prime rate charged by banks, typically one to two percentage points above the rate, and it can change as the prime rate changes. As of October 2022, the average prime rate is 6.25%, so the interest rate on a 401(k) loan can run between 7.25% and 8.25% or higher. That compares favorably to credit card rates and the average home equity line of credit rate.
Interest is paid to your account
The interest you pay is paid to your account. In other words, you earn the interest because you are the lender, which is certainly more appealing than paying it to someone else. However, while that may help to replenish your account, you still miss out on the compounding returns your money would have earned had it remained invested.
No credit check or reporting
One of the more appealing aspects of borrowing from your 401(k) is there are no credit checks. The only issue you face in getting a loan is whether your employer allows it and any restrictions they might place on it. Also, 401(k) loans are not listed as debt on your credit report, and payment (or nonpayment) activities aren’t reported to the credit bureaus.
No taxes or penalties, unless…
Funds received via a 401(k) loan are not taxed, making them a better alternative to taking early withdrawals, which also results in penalties. However, borrowers still risk paying taxes and penalties if they fail to repay the loan on time.
Quick and convenient access
All that is required to take out a 401(k) loan is filing some paperwork with your employer’s human resources department. You will need to specify which investment accounts are to be used to provide the funds. You may be required to pay a modest loan origination fee, but there are no other costs. With most plans, you will be required to set up automatic payments from your paycheck.
*A critical caveat to be mindful of is all this works well only if you stay with your current employer. If you leave your employer (and your 401(k) plan) before the loan is fully repaid, your outstanding balance could be deemed an early distribution subject to taxes and an early withdrawal penalty. To avoid taxes and the penalty, you must repay the loan in full by the tax filing deadline in the year following your departure.
Reasons for a 401(k) Loan
Though it’s relatively cheap and convenient to borrow from your 401(k), and the funds can be used for any purpose, it’s not advisable to do so except for a very good reason and if you don’t have a better option. That’s because taking a 401(k) loan can potentially hurt your long-term retirement planning.
As with any loan, it doesn’t make sense to use funds on anything that doesn’t provide lasting value, such as a home purchase or college education. It would certainly be foolish to tamper with your retirement funds to pay for a vacation or an expensive gift.
It can also make sense if you plan and have the ability to repay the loan within a year. A short-term 401(k) loan will impact your retirement savings less than if you extend the repayment period to the full five years.
Should I use a 401(k) loan to pay off high-interest debt?
On the surface, using a 401(k) loan to pay off high-interest debt seems to make sense. You could save a lot of money by lowering your interest costs. Plus, with the short, five-year timeframe for repaying a 401(k) loan, you know you can pay it off quickly.
But what if you don’t? If you fail to repay the loan within five years, you will be subject to ordinary income taxes on the balance due, as well as a 10% penalty.
It may make more sense to consider a debt consolidation loan, which can also lower your interest costs, but it won’t put you in arrears with your own retirement plan.
What if I have a financial hardship?
If you experience a financial hardship, you may qualify for an early withdrawal exemption through your 401(k). That would allow you to withdraw funds early (before age 59 ½) without incurring a penalty (though you will owe taxes) and without the requirement of paying it back.
The IRS defines a financial hardship as “an immediate and heavy financial need,” such as
- Certain medical expenses
- Preventing an eviction or foreclosure
- Emergency home repairs for uninsured losses
- Some costs for buying a principal home
- Tuition, fees, and education costs
Not all hardships may qualify for an early withdrawal exemption, so it would be essential to check with your human resources department for guidance. If you’re turned down for a hardship waiver, you can always borrow from your 401(k). Also, check into the restrictions on allowable distribution amounts for certain hardships, which, if exceeded, can result in a 10% penalty.
401(k) Loan Pros and Cons
We’ve already mentioned some of the pros and cons of borrowing from your 401(k), but we’ll summarize all of them here:
401(k) Loan Pros
- Fast and convenient
- Flexible repayment terms—no prepayment penalties
- Low borrowing costs
- No credit check
- Doesn’t affect your debt-to-income ratio
- No explanation necessary
- Interest is paid back to your account
401(k) Loan Cons
- Your accounts could grow more slowly
- If you default, you will owe taxes and penalties on the outstanding balance
- If you leave your employer, your repayment schedule is accelerated
- You are repaying the loan with after-tax dollars
Tips for Borrowing from Your 401(k)
If you do find yourself needing a 401(k) loan, there are ways to optimize its use while minimizing the downside.
Pay it Off Fully and Promptly
At a minimum, you must be certain that you are able to repay the loan fully within five years. Otherwise, the taxes and penalties you’ll owe could not only set your retirement plans back but could also make a severe dent in your current cash flow.
For an optimum outcome, having a plan to repay the loan within a year—two at the most—will maximize the cost-benefit of the loan while keeping the impact on your retirement funds to a minimum.
Try Not to Borrow too Much or too Often
Another attractive feature of a 401(k) loan is there is no limit to the number of times you can take one as long as you stay within the borrowing limit of the plan. Once a loan is repaid, you are able to take out another one. However, that would have the same effect as taking out a long-term loan, which reduces the cost-benefit and increases the impact on your retirement savings.
Keep Making Contributions
Ideally, the need for a loan should not derail your retirement savings plan. If possible, it would be essential to continue making monthly contributions to your plan. That would be especially important if your employer makes matching contributions. The more your accounts grow in value, the less of an impact the loan will have long-term on your retirement plan.
However, some 401(k) plans have provisions prohibiting contributions with an outstanding loan. If that’s the case, you should have a plan to pay the loan off as quickly as possible so you can resume your contributions. You can also see if you’re eligible to set up a Roth IRA and direct your contributions there.
401K Loan Alternatives
Generally, a 401(k) loan is a better option than taking early withdrawals because you can avoid taxes and penalties. And, unlike a withdrawal that doesn’t have to be repaid, a 401(k) loan requires repayment, which means you will be replenishing your investment accounts.
However, depending on your circumstances, there may be several alternatives that can put less stress on your retirement.
Take out a HELOC
If you own your home and have sufficient equity, you can establish a home equity line of credit (HELOC), allowing you to take out the money you need, when you need it, up to your credit limit. Like a credit card, a HELOC is a revolving credit line. As you repay the borrowed funds, it replenishes your credit line. Your interest payments may also be tax-deductible depending on how they are used.
Get a Home Equity Loan
A home equity loan is a fixed-term loan typically with lower interest rates than a HELOC. However, it is an installment loan requiring fixed monthly payments, so it would be important to determine precisely how much you need to borrow. A home equity loan is generally easier to get than a HELOC, but it’s critical to be mindful that your home is used as collateral to secure the loan.
Use Your Health Savings Account
If you have a health savings account (HSA), you can use the funds to pay for qualified medical expenses without tax consequences.
Tap Your Roth IRA
If you have also been contributing to a Roth IRA, you are allowed to make tax-free withdrawals of your contributions with no penalty no matter your age.
Take From Your Emergency Savings
Your emergency savings can also be a source of funds, but it would be necessary to replenish it as quickly as possible.
If your goal is to pay down high-interest credit cards, you could consider a balance transfer credit card. With good credit, you can qualify for a zero- or low-interest balance transfer card that would allow you to lower your interest costs so you can pay it down more quickly. The major caveat is that balance transfers must usually be repaid within 12 months (some cards offer 18-month terms), or you could end up paying the default interest rate and penalties on the entire transfer amount, regardless of how much you have repaid.
Get a Personal Loan
This may be the least attractive alternative, but it may be preferable to jeopardizing your retirement plan. Personal loans are quick and easy to get, but their interest rates can be high. If your financial need is short-term (a year or less), this could be a better option than a 401(k) loan.
The availability of loans is an attractive feature of 401(k) plans. They are convenient and relatively inexpensive without the credit hassles. However, they can also be a curse without proper planning and careful consideration of the drawbacks. At the end of the day, taking funds from your 401(k) early, permanently, or temporarily has the potential to derail your retirement plan.
That’s why it’s critical to have a sound plan in place for repaying the loans as quickly as possible while monitoring your progress toward your retirement goal. Working with knowledgeable financial advisors at Dechtman Wealth Management, we can help you prepare for the challenges of meeting your short-term needs while staying on track for a secure retirement.
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