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401(k) Loans: Yay or Nay?

In today’s tough economy, you may find yourself struggling to cover your day-to-day expenses. But rising interest rates are making traditional loans more expensive. In such an environment, you might consider borrowing funds from your 401(k) retirement account, if your plan permits it. But you’ll need to weigh the pros and cons before taking the plunge.

Nuts and Bolts

It’s important to review how 401(k) loans work. The first step is to ask your employer about loan options under its plan. If loans are permitted, your employer can provide the requisite paperwork.

The IRS limits such loans to the lesser of:

  • $50,000, or 
  • 50% of your vested account balance. 

For example, if your vested balance is $70,000, you can borrow up to $35,000. If the vested balance is $140,000, you can borrow up to $50,000. (However, your plan might impose lower limits.)

Borrowers usually have five years to repay a 401(k) loan. But there’s generally a longer payback period if the funds are used to purchase a primary residence. The loan repayments must be made in substantially equal payments (of both principal and interest), at least quarterly, over the life of the loan. Typically, your employer will withhold some principal and interest from every paycheck after the loan has been disbursed.

Potential Pros

Borrowing from your 401(k) may seem appealing for multiple reasons. It provides fast access to cash, with no credit check or application process. You don’t have to explain to anyone why you need the money or how you intend to use it.

Plus, you won’t be on the hook for income tax on the money or the early withdrawal penalty (which applies to borrowers under age 59 ½ years with a 401(k) withdrawal). The interest rate on a 401(k) loan also tends to be lower than those available from a commercial lender or on credit cards. Moreover, you pay the interest to yourself, rather than a lender. 

And the loans aren’t reported to credit bureaus. As a result, the loan won’t affect your credit score, even if you miss payments or default.

Cautionary Cons

That said, 401(k) loans also come with some significant drawbacks. Perhaps the most obvious is the missed opportunities for growth on the money pulled out of your account. 

It’s not just the benefits of soaring markets you could forfeit, though — some plans don’t allow ongoing contributions while you have an outstanding loan. Even if your plan does permit you to contribute, you may not have the extra cash for contributions while you’re also paying back the loan. If your employer makes matching contributions, you’re leaving that money on the table.

Fees are another consideration. For example, you may be required to pay origination and maintenance fees. Fees on 401(k) loans can be higher than those for a conventional loan. 

Further, 401(k) loans lead to double taxation. That’s because you make repayments with after-tax dollars and then will be taxed again when you withdraw the money in retirement.

You also make the loan funds vulnerable to claims from creditors. The Employment Retirement Income Security Act of 1974 protects 401(k)s from creditors, but funds lose that protection when they’re not in the account. 

The risks don’t end there. If you default on the loan for any reason, the remaining balance is deemed a distribution. You’ll have to pay income taxes on it in addition to the 10% early withdrawal penalty, if applicable.

If you leave your job before the loan is repaid in full, the loan balance will be due immediately (depending on the plan terms) or by the tax return filing date for that tax year. For instance, if you quit your job in 2022, the balance will be due by April 17, 2023, or October 16, 2023, if you extend your filing date. If you’re unable to pay the balance, it’ll be treated like a default, meaning you’ll owe both income taxes and the early withdrawal penalty depending on your age.

Hardship Withdrawal Alternative

Your 401(k) plan may offer so-called “hardship withdrawals,” subject to conditions set by your employer. If permitted under a plan, the IRS requires that the distributions be due to an “immediate and heavy financial need” and limited to the amount necessary to satisfy that need. Certain needs are automatically considered eligible, such as medical expenses for employees and their spouses and dependents.

Several restrictions apply. For example, you can’t repay the hardship distribution or roll it over to another plan or an IRA. In addition, the distributions are subject to income tax and the early withdrawal penalty.

Proceed with Caution

A loan from your 401(k) may provide a much-needed safety net, but it generally should be treated as a last resort, after exhausting all the other alternatives. If you find yourself in need of cash, consult with your financial advisors. They can help you explore all of your options and minimize the negative short- and long-term financial consequences.