Are you thinking about borrowing money from your 401(k) plan? Whether it is for the down payment for your home purchase, for debt payment, to fund your new business venture, or to cover your cash shortfall; borrowing money from your 401(k) is a decision that you need to consider carefully.
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How to Get a 401(k) Loan
The exact procedure is slightly different from plan to plan, so be sure to talk to your benefits office or your plan administrator for the specifics. For some plan, it is as easy as logging in to your 401(k) website and find the link to “Request a Loan.”
1. Determine How Much You Can Borrow
Your HR office or the Plan Administrator will be able to help you figure out exactly how much you can borrow. For one of my plans, I simply logged in to their website and clicked on “Request a Loan.” The next screen tells me that I can borrow $26,540.21, according to the website:
In general, the IRS guideline is the lesser of 50% of your vested account balance, or $50,000 minus your highest outstanding loan balance in the last 12 months.
2. Determine How Much Interest You Have to Pay
401(k) loan interest rates are usually one or two points higher than the prime rate, and the plan sets the rate.
However, this is not the same as borrowing from your bank or other lenders, because you’re paying the interest back to yourself.
The money you borrowed is no longer invested and you could lose out on any potential investment gains; however, you are earning interest that you’re paying yourself.
For my plan, the current interest rate as of July 2019 is 6.5%; plus there is a small loan origination fee of $150 (your fee will be different)
3. Determine How You Will Pay Back The Loan
Again, this is plan specific. For my plan, there are two types of loan: General Purpose Loan vs. Principal Residence Loan.
- General Purpose Loan has a repayment term of 12 to 60 months
- Principal Residence Loan has a repayment term of 61 to 360 months
Both loan repayments are automatically deducted from each paycheck after taxes. Depending on the amount you borrow, and the repayment term, the amount deducted from each paycheck will be different. For example, for a $25,000 loan, these are the repayment amount that will be deducted from each Bi-Weekly paycheck:
- 12 months term = $1,074.53
- 24 months term = $532.53
- 36 months term = $361.60
- 48 months term = $277.98
- 60 months term = $228.47
In general, you should pay back as quickly as possible while not putting yourself in further financial jeopardy.
401(k) Loan Advantages
Borrowing money from your 401(k) is easy. It is probably too easy because I can do my 401(k) loan application online. In my opinion, there should be a consultation requirement before you can take out a loan.
2. Inexpensive and You’re Paying Yourself Interest
It is less expensive than some of the alternatives, especially a credit card cash advance or a payday loan. And unlike other loans, you are not paying someone else interest. The interest you pay goes into your 401(k) account.
3. Flexible Repayment Terms
As you can see from the example above, you can easily pick and choose the best loan repayment terms that work for you; whereas most other loans have specific repayment terms imposed by your lender.
4. No Credit Check
Unlike other loans, no credit check will be performed when you take out a 401(k) loan because you are not borrowing money from someone else (you are borrowing from yourself).
5. No Income Taxes or Penalties
401(k) Loan Disadvantages
1. Opportunity Cost
When you borrow money from your 401(k) the amount is withdrawn from your investment. Since the market has an average annualized gain of about 9%, your borrowed money could be losing out on any potential gain.
2. Contribution Risk
Some plans do not allow you to contribute new money to your 401(k) while there is an outstanding loan. Or you might not be able to contribute your normal amount because a significant portion of your paycheck is going toward loan repayment.
This could hurt you significantly in three ways:
- You lose the ability to add new money to the plan, and the growth potential of that money with it.
- You lose free money in the form of the company’s matching contributions (if your company offers this).
- You lose the ability to deduct your 401(k) contributions from your taxable income to reduce your taxes.
For example, if you regularly contribute $500 a month and your company matching contribution is $100, over the course of one year, you will have $6,000 less in retirement savings, lose $1,200 in free money, and give up $1,680 in tax deduction (assuming a total combined tax rate of 28%).
3. Loan Repayment After Leaving Your Job
If you leave your job for any reason — i.e., you got fired, or you quit — you are required to pay back the entire loan balance usually in 60 days. If you are unable to pay back:
- You will be taxed on the amount owed at your marginal tax rate (or higher).
- You will be assessed a 10% early withdrawal penalty.
- You will lose the ability to put that money back to work for you as retirement money, leaving you less to retire with.
For example, if you owe a balance of $10,000 when you leave your job and your marginal tax rate is 28% (federal and state), you’ll have to pay $2,800 in taxes and $1,000 in the early withdrawal penalty. Plus, your retirement fund will be permanently lowered by $10,000.
4. Loss of Bankruptcy Protection
To Borrow or Not Borrow from Your 401(k)
- To Cover Cash Shortfall – if your cash shortfall is a short-term and small amount, you might be better off working on your budget. There are ways you can quickly reduce your expenses and earn extra money on the side.
- For Home Purchase – this might be a good reason to borrow as long as your budget can accommodate both your new mortgage payments plus 401(k) loan repayments. The problem many people face is that having another loan of top of the mortgage becomes too overwhelming.
- To Pay Off Debt – if you’re paying high-interest loans like credit card debt and payday loan, this could be a good solution…at least mathematically. Be sure to read How to Get Out of Debt Fast before you go down this road.
- To Fund a Business – Starting a business is risky enough on its own. The failure rate is very high. I do not feel this is a good reason for anyone to borrow money against their 401(k).
- For a Vacation or Car Purchase – these are probably the worst possible reasons to take out a 401(k) loan. If you cannot afford a vacation or a car without borrowing money, just don’t do it.
How Does 401(k) Loan Affect Taxes
You may have read somewhere that when you contribute to your 401(k), you are doing so with pre-tax dollars. To be precise, you are paying FICA and Medicare taxes, but your contribution is tax-deductible against your Federal and State Income taxes. However, when you are paying back the loan, you are doing so with after-tax dollars, and you’ll get taxed again when you finally withdraw the amount during your retirement. The example usually goes something like this:
If you borrow $10,000 from your 401(k) plan and your marginal tax rate is 25%, you’ll have to earn $13,333 to pay back the entire loan (before factoring in the interest).
401(k) loan double taxation is a myth. It doesn’t matter where you borrow the money from; you will have to pay back the loan with after-tax dollars.
Think about it, if you borrow from your bank, you pay back with after-tax money. If you take it from your savings, you refill it with after-tax dollars.
Here are some excellent articles that help dispel the myth:
- Double Taxation and the Real Reasons 401(k) Loans Are Bad at My Money Blog
- 401k Loan Double Taxation Myth at the Financial Buff
Better Alternatives to Borrowing From 401(k)
As you can see, the price for borrowing from your 401(k) could be very steep. But what are some of the options you have if you need the money? Here are a few ideas:
- Reduce your expenses — This is probably the easiest way to free up some money. Are there any recurring expenses that you could reduce? Are there any planned expenses, such as a vacation, that you could defer? Are you practicing frugality?
- Increase your income — Looks for things that you could do to generate income. There are many ways to do this ranging from building alternative income streams, working a second job, and selling your possessions.
- Borrow money from peer-to-peer lending networks.
- Cash out mortgage refinancing.
- Borrowing against a cash-value life insurance policy.
Have you considered borrowing from 401(k) before? What did you do? Why? Please share your story.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.