Can I take a loan from my 401(k)?

Suppose you just experienced a significant financial crisis, maybe an uninsured piece of property was destroyed, or your children are all in college at the same time. As a fiscally responsible person, you have been depositing money into your company-matched 401(k) since you got your first job in high school.

The account has grown over the years, and it seems logical to borrow from your 401(k) to get yourself over a financial rough spot, but is it a good idea? Before touching your 401(k), it is important to understand whether it is possible to take a loan from your 401(k) and the financial impact of borrowing from it.

What is a 401(k) account?

A 401(k) is a tax-advantaged retirement savings plan your employer sponsors. It allows employees to save and invest a portion of their earnings by depositing some of their paychecks before taxes are calculated and taken out. Your 401(k) contributions are not taxed until the money is withdrawn, typically after you retire. Early withdrawals may be subject to penalties and income taxes.

Since it is tax-advantaged, a 401(k) has a contribution limit that is adjusted based on inflation. Many employers will match your contributions up to a certain percentage. Contributions to your 401(k) plan are invested in a variety of stocks, bonds, and mutual funds.

Unless your employer or plan administrator has restrictions, you can typically borrow up to half of the vested account balance in your 401(k) or up to $50,000, whichever is less. You must repay the loan following the rules that are designed to restore your 401(k) to the state it was in before you borrowed money. Besides the principal, you also repay the interest the money would have earned.

How do you pay interest on your own 401(k)?

When you make payments on your loan principal and interest, the money is deposited into your account and invested. You pay the interest on your loan using post-tax dollars. The interest is treated as taxable earnings in your 401(k). This money is taxed a second time when you withdraw it from your 401(k) during your retirement.

Borrowing money against a 401k

As mentioned, you can borrow money against your 401k. However, not all employers offer such an option, so it is best to check with your HR department or plan administrator. If your employer does allow for 401k loans, there are certain rules and limitations that you should be aware of. Generally, you can borrow up to 50% of your vested account balance or $50,000, whichever is less. 

Keep in mind that you will need to repay the loan within a specified time frame, and there can be other financial consequences.

Can you be denied a 401k loan?

While it is generally possible to take a loan from your 401k, there are situations where you may be denied. For example, if your employer does not offer loan provisions in their 401k plan, you will not be able to borrow against it. Additionally, there may be restrictions on the number of loans you can take or limitations on the amount you can borrow. 

As your fee-only financial planner, I can review your plan’s rules and regulations to help you understand the specific criteria for loan approval.

Risks of taking out a 401(k) loan

Before considering a 401k loan, you should always understand the potential risks involved as well as the benefits. One major risk is the opportunity cost of missing out on potential investment growth. By taking a loan, you are reducing the amount of money you have invested, thereby limiting the potential earnings on those funds. This can have a significant impact on your long-term retirement savings. When you have a trusted financial planner, I can review other options to potentially provide financial support and protect your investment power.

Another risk is the potential for defaulting on the loan. If you are unable to repay the loan within the specified time frame, typically five years, it will be considered a distribution. This means that the remaining balance will be subject to income taxes and, if you are under the age of 59 1/2, a 10% early withdrawal penalty. Additionally, if you leave your job before repaying the loan, you may be required to repay the balance in full within a very short period of time.

These are all important considerations to discuss with an experienced fee-only financial planner like myself at Frame Wealth Management.

Advantages of borrowing from a 401(k)

While there are risks associated with taking out a 401k loan, there are also advantages that may make it a viable option for some individuals. One advantage is that the interest you pay on the loan is generally paid back into your own account. This means that you are essentially paying yourself back the interest rather than giving it to a lender.

Another advantage is that 401k loans do not require a credit check. This can be beneficial for individuals with less-than-perfect credit scores, as they may still be able to borrow from their 401k even if they would be denied a traditional loan.

Other alternatives to a 401(k) loan

While a 401k loan may seem like a convenient option, it is important to consider alternative options before making a decision. One alternative is to explore other sources of financing, such as a personal loan from a bank or credit union. These loans may have lower interest rates compared to 401k loans and may not have the same risks associated with potential default.

Another alternative is to reassess your financial situation and make adjustments to your budget. By cutting expenses and increasing savings, you may be able to avoid the need for a loan altogether. Additionally, speaking with a fee-only financial planning advisor, such as Frame Wealth Management, can provide valuable insight and guidance on alternative strategies to meet your financial needs.

When does a 401(k) loan make sense?

When you borrow from your 401(k) account, you lose the opportunity for these funds to grow tax-deferred within your plan. This opportunity cost must be compared to the amount of interest you would be charged if you borrowed the money elsewhere.

If you find yourself in need of cash for a short-term need, a 401(k) loan can make sense. Short-term loans, especially payday loans, come with a high interest rate and must be repaid quickly.

Typically, a 401(k) loan must be repaid according to a fixed repayment schedule over no more than five years, with payments made at least quarterly, unless the loan is used to pay for a primary residence.

If you borrow money from your 401(k) and repay the principal and interest, the loan should have no impact on your retirement since any lost investment earnings will be offset by the interest paid into the account.

If you cannot afford to pay back your 401(k) loan and continue to make contributions to your 401(k) at the same cadence as you were before the loan, this can impact your retirement portfolio, especially if you miss out on your employer’s matching contributions.

What happens if you leave a job before you pay back your 401(k) loan?

If you lose your job before you pay back your 401(k) loan and the plan sponsors require repayment if your job or the plan is terminated, the entire unpaid loan balance may be considered a taxable distribution. You could face a 10% federal tax penalty on the unpaid balance if you are under age 59½, unless you qualify for another exemption. You can avoid these tax consequences by rolling over all or part of the loan’s outstanding balance to an IRA or another eligible retirement account before the due date for filing income taxes that year.

Before borrowing from your 401(k) account, consult with a financial planner. They can help you weigh the opportunity cost of taking a 401(k) loan versus borrowing from another financial institution or source.

There’s no one-size-fits-all approach to investing. A wealth manager can help you make the right financial decisions for you and your family. Contact us to get started.