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How Does a 401(k) Loan Work, Advantages and Disadvantages

How Does a 401(k) Loan Work, Advantages and Disadvantages

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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.

How Does a 401(k) Loan Work, Advantages and Disadvantages 1

Table of Content

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

1. Easy

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

The money you borrow from your 401(k) plan is not taxed, and you don’t pay any penalty unless you default on the loan.

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:

  1. You lose the ability to add new money to the plan, and the growth potential of that money with it.
  2. You lose free money in the form of the company’s matching contributions (if your company offers this).
  3. 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:

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

Lastly, your retirement savings are generally sheltered if you file for bankruptcy. However, the amount you borrowed is no longer protected. Basically, you could lose it all.

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:

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.

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B Smith
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B Smith

Wow, I can’t imagine a worse way to finance a business than using your 401K. I also don’t generally think it is a good idea to start a business with a large chunk of money. I rarely find more than $10k is necessary, and often you can start with much less. We started all our businesses (five in various industries) on $500 or less. All have been successful and made money in the first year. This topic alone is deep enough to write a series of articles. Three key advantages of starting a business on a shoestring: -It forces you… Read more »

Kevin
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Kevin

I think there should be a rule that eliminates the ability to take the money out unless you have a hardship exception. Just so many reasons to NOT do it…

The thing about starting a business is there is great risk and potential great reward. The only problem is when you are on the start up side you think you are invincible and your product is going to be an immediate hit. Usually not the case.

Heidi
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Heidi

I would only advise an early 401(k) distribution or loan for a catastrophic need. It is an extraordinarily bad idea to fund a business venture with retirement savings. The risk involved with a new business way outweighs the potential upside, even if this person feels that his endeavor is a “sure thing.” Trust me – I’ve seen several new business owners go through heart-breaking bankruptcies. It’s just a bad, bad idea.

Paul
Guest
Paul

I borrowed against my 401(k) for some extra spending money. Ironically enough, I have spent less than I borrowed, yet I can’t pay back the loan early without a penalty. So, I invested the money, which has turned out to be a windfall, and made even more money than I first took out. I’ll finally have the loan paid off in July (took out a two year loan) and will be extremely happy to have all that money back in my pocket (or really redirected to a Roth IRA) rather than paying for a loan that I never should have… Read more »

Ralph
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Ralph

On the one hand it doesn’t surprise me a bit that someone would consider a loan from 401K as a good place to look for venture capital. On the other hand, I’m so involved in personal finance that it just seems nuts to me. However, the fact of the matter is that many people consider any large stockpile of cash as a place to pull funds from when they have an emergency or idea. It’s just a good thing that he talked to you first. Playing the devil’s advocate though; It could end up being the best thing ever for… Read more »

TC
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TC

I did it when quitting a good job due to burnout. Sure, I had some money to tide me over, but I ended up declaring bankruptcy anyway down the line. Both huge mistakes. I asked people for advice at that time, but the people I chose were either not invested in really helping me, or were actually invested in me making these mistakes. The taxes were a killer, and I am just now truly recovering. Yes, I had a hardship, but not a catastrophic one, and I should have found other ways to survive. However, I think this period in… Read more »

Lazy Man
Guest

This would be one case where I’d look at Prosper.com

Clint
Guest

Your 401k is not always the best place to put your money. If you could instead save that money and use it to start a business you have the potential for much higher returns. However, most people wont realistically do that, and for them the 401k is one of the better places to be putting your money. And, as you advised, if you’ve already been putting you money in your 401k, it’s usually a bad idea to borrow from it.

Fred
Guest
Fred

I don’t want the government to say that you can’t withdrawal money from your 401(k), but it rarely is a good choice. There are so many better ways to get a quick loan.

Nick
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Nick

For the people who say investing in a 401k is a bad investment you could be right or wrong but only in one manner… What is the company match? For people who think the free money thing is a scam they are incorrect. If you put 100 dollars in a bank for a year and earn 5 percent interest ( and no one will earn that in a bank account) you will earn 5 dollars. If you contribute 100 dollars to your 401k and you company matches 100 percent you now have 200 without even considering the investment.. That’s a… Read more »

David
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David

I would be interested in hearing some opinions on my situation. I am going to school at night, I work full-time during the day, and I am in a deep financial mess. I have a 401K plan that I have now had for 20 years. I was considering taking out a loan. My salary dropped almost $10,000 last year. The recent recession has hurt me more than I thought, and I already have an equity loan that I am paying on. My daughter is starting her second year at college and there are supplies(computer, etc) that I am trying to… Read more »

Peter C Krieger
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Peter C Krieger

Does anyone ever consider using a 401K loan to make an deductible (or non-deductible) IRA contribution? Here’s an example: You have a $10,000 balance in your 401K plan, and $6,000 balance in a deductible IRA. Your total retirement savings @ this point is $16,000.00. If you take a $5,000.00 loan from the 401K plan, and use that to make a deductible IRA contribution. Your 401K is now $5,000.00 but your IRA is now $11,000.00 leaving you with $16,000.00 of retirement assets. You (hopefully) get a tax deduction you otherwise would not have had; you have more choice over where to… Read more »

ken levy
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ken levy

Whatever you do never ever borrow from your 401k plan at work. I did in 1997 to finance a move to Alaska. It was the worse mistake I ever made in my life. Today I am retired living on SS and a very small pension check. There are no jobs where I live even if I wanted one. I will be 66 soon and no one will hire you at that age no matter how much experience you have. Now that I should be in a stress free time in the twilight of my life I am having to sell… Read more »

Nick
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Nick

I am thinking of barrowing from my 401K to pay off a credit card. Since the market is not gaining and I am actually losing money each quarter is this a good idea? The amount barrowed is around $7,000.00 My company does not match.

Monjon
Guest
Monjon

The double taxation is a total myth. Probably perpetrated by well-meaning TV and Radio financial ‘experts’. No matter where you borrow money from (tax-shelter, bank, Mom, brother, Credit Union… etc.) you pay it back with taxed dollars. People focus on the borrowed money, when you should look at the product you buy with the borrowed money. Example: borrow $1000 to buy a refrigerator – or for that matter pay cash for it. Either way you pay for it with taxed dollars. By using a tax-sheltered account to borrow from you still pay the tax on the dollars you use to… Read more »

Brent Pittman
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Brent Pittman

I cashed out my 401K more than 5 years ago in order to pay off grad school, buy a ring, and get married. That was before I learned about money. I now joke with my wife that her ring and honeymoon would have been much smaller and delayed if I had known about investing.

Confused
Guest
Confused

I quit my job over a month ago and have a loan of about $1200 left to pay on. Of course I dont have the money to pay this loan off. I haven’t heard from the plan administrator about the balance due. I have $22K in the account. I’ve been interviewing but don’t think I’ll meet the 60 day deadline. Is it best to take the penalty and invest the money elsewhere until I find a job?

Maria Smith
Guest
Maria Smith

The worst case scenario happened to a friend of mine – he took his 401K money – pretty much all of it and invested it in a business that was supposed to be a big money maker – but after they ordered and paid for the manufacturing machines, and before delivery, the company that made the machines went bankrupt. Getting back 10 cents on the dollar in bankruptcy court some time later. 15 years later he is 75 years old and still working, with no 401K… Remember – small businesses have a very high failure rate – and success or… Read more »

J Smith
Guest
J Smith

My Wife and I have bad credit, around 450-500 bad. So a loan from anyone is not really an option for us at this time(we’ve tried). My wife and I were unemployed and burned up everything except our 401k’s trying to stay afloat. Long story short we are rebuilding and trying to recover. We both have great new jobs with a lot of potential. It will take time to recover our financial health. With that said we need money immediately to replace tires and much needed repairs on our cars. Until now I have avoided touching our 401K money but… Read more »

How Does a 401(k) Loan Work, Advantages and Disadvantages

by Pinyo Bhulipongsanon time to read: 6 min
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