Essential Facts to Understand Regarding 401(k) Borrowing Options

Using your 401(k) as a source of funds during tough times is a popular strategy.

This plan has its advantages, such as not needing excellent credit to qualify for a 401(k) loan and paying interest to yourself instead of a lender. Some individuals think these benefits outweigh the significant drawbacks, like missing out on potential returns on the borrowed cash.

If you're contemplating whether tapping into your retirement savings is the best course of action, here are seven crucial pieces of information to understand.

1. You can borrow up to $50,000 or half of your vested balance.

A 401(k) loan is limited to the lesser of $50,000 or 50% of your vested contributions. However, you can only borrow as much as you have in your 401(k), so if your balance is smaller, you won't be able to take out a loan for the maximum amount.

2. You typically have five years to repay the loan.

Repaying a 401(k) loan within five years of borrowing the money from your account is essential to avoid early withdrawal penalties and other tax consequences, as discussed below.

3. Not all 401(k) plans offer this option.

Not all 401(k) plans allow you to borrow against your retirement savings. If your employer doesn't allow it, this option won't be available to you. Check with your plan administrator to see if borrowing is an option and what the maximum loan limits are.

4. What happens if you leave your job?

If you leave your job, you may have to repay the loan within the following year. However, the rules changed in 2018 under the Tax Cuts and Jobs Act, giving you until Tax Day of the year you took the loan to repay it.

For instance, if you took out a loan in 2024, you'd need to repay it by April 15, 2025, or October 15, 2025.

The extended deadline reduces the risks of borrowing slightly, but if you take out a loan and then lose your job unexpectedly, it could be challenging to repay the loan in full.

5. What if you default on the loan?

If you fail to repay your 401(k) loan, the defaulted loan is treated as a withdrawal or distribution and is subject to a 10% penalty for early withdrawals before age 59 1/2. This can be a significant cost, especially when you consider the lost potential gains your money would have earned if left invested.

6. You'll pay interest to yourself.

When you borrow against your 401(k), you must pay interest on the loan. The good news is you'll be paying that interest to yourself. Your plan administrator will determine the interest rate, typically based on the current prime rate.

The downside is that you'll pay interest on your 401(k) loan with after-tax dollars. When you take money out in retirement, you'll still be taxed on the distributions at your ordinary income tax rate. This means the money will be effectively taxed twice – once before using it to pay back your loan and again upon withdrawal.

The interest you pay yourself is usually less than what you would earn if you had left your money invested.

7. Is a 401(k) withdrawal an alternative to a 401(k) loan?

A 401(k) loan is generally preferable to a 401(k) withdrawal if you must use funds from your retirement account for your immediate needs. A loan is a better option because:

You avoid the 10% early withdrawal penalty that applies if you take money out of your 401(k) before age 59 1/2.
You'll repay the money to your 401(k), ensuring it doesn't lose out on potential investment gains.

Before considering a 401(k) withdrawal and incurring the penalties and losses for the remainder of the time until retirement, consider taking out a loan instead if your plan allows it.

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Consider the pros and cons before taking out a 401(k) loan

Always carefully consider the advantages and disadvantages before borrowing against your retirement account. Your financial future is at stake when you withdraw invested funds that should help build security for your later years.

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After considering a 401(k) loan, one might also think about alternative sources of funds for retirement, such as adjusting their retirement savings plans or exploring other financial investment opportunities.

Additionally, while a 401(k) loan can offer advantages like avoiding early withdrawal penalties and paying interest to oneself, it's essential to remember that failing to repay the loan could result in significant costs and taxes, potentially impacting your retirement savings in the long run.

Essential Facts to Understand Regarding 401(k) Borrowing Options