Why You Should Think Twice Before Borrowing Against Your 401(k)

If you’re thinking about borrowing against your 401(k), tread carefully. Not only would you be messing with your retirement savings, you’ll also be running the risk of incurring penalties. If not handled carefully, you could also have less money saved than you planned when you’re ready to retire.

However, life happens, and we get that. If you seriously need access to cash for a short-term need, borrowing from your 401(k) may be a last resort option. 

At the same time, know that there are strict rules for 401(k) loans. 

What is a 401(k) loan?

A 401(k) loan is essentially borrowing money from a 401(k) retirement plan.  Unlike typical loans, borrowing from your 401(k) does not involve credit checks or working with a bank. With a 401(k) loan, you’re borrowing against yourself, and you usually don’t have to explain why you want the loan.

Once you borrow from your 401(k), you’re required to pay it back, generally with interest and within a set time-frame.  

Whether it’s even possible for you to borrow against your 401(k) depends on your employer, your 401(k) plan and your vested account balance. 

However, there’s a lot more to choosing a loan than whether or not there’s a credit check; borrowing against your retirement account could include some significant downsides.

401(k) loan rules

Your 401(k) plan will set the amount you’re allowed to borrow, but generally it’s up to 50% of your vested account balance and a maximum of $50,000. The IRS requires that the loan must be repaid within five years, unless the loan is used to buy your primary residence. Additionally, the loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan. 

The interest rate you’re required to pay is set by the 401(k) plan administrator and is generally closer to the prime rate and lower than typical bank loans.  

These are the general rules, but it’s a good idea to defer to the rules of your 401(k) plan since each plan is different. 

Why a 401(k) loan could hurt you 

First, if you’re borrowing against your 401(k), you’re not just tapping into any pool of money – you’re taking money out of an account you created for your future, which means you’re potentially messing with your long-term savings for retirement.

Let’s say you pulled $25,000 out of your 401(k) balance. Considering an average rate of return of 7% over five years invested in the stock market, at the end of the five years, your money could have grown to $33,377. And if kept in your 401(k), that money could’ve been worth exponentially more in ten to twenty years.    

This loan can put retirement plans on the back burner: you’re earning less interest because your balance is smaller.

Another consideration is the repayment requirements:

• You need to repay your loan in five years or it counts as a 401(k) distribution.
• If you’re not at least 59 ½ years old and haven’t repaid your loan in time, you could get hit with a 10% penalty for withdrawing your money early.
• If you leave your job, you may need to repay your loan sooner than you expect: Depending on your plan, you may need to come up with the balance within 90 days or by the time you file your income taxes. Check with a financial advisor and/or your 401(k) administrator to see when you may need to pay up.

On top of these reasons, your money will be double taxed if you borrow from your 401(k). Unlike your initial contributions, which were made with pre-tax dollars, you can only pay back your 401(k) with after-tax income. Once you retire, the money that you that borrowed and then re-payed will be taxed again when you withdraw it.

If this has you thinking twice about borrowing against your 401(k), there are alternatives that could help you keep your retirement savings on track. Here are a few:

Personal loan

Yes, you are taking on more debt, but you won’t have to worry about potentially having an early withdrawal penalty like you would if you were to take out a 401(k) loan and couldn’t pay it back on time. There are personal loans that have no fees, and having an excellent credit score can increase your chance of getting the most competitive interest rates. 

Home equity line of credit (HELOC) and Home Equity loans

Borrowing against the equity in your home using a HELOC or home equity loan could provide a relatively low-interest option, compared to credit cards, provided that you have built up enough equity in your home to qualify for a HELOC.

Also known as a second mortgage, when used on the right home improvements, a HELOC could be a way to finance repairs that could in turn increase the value of your home. 

Savings and Emergency funds

You set aside money for emergencies… for emergencies, so it may be worthwhile to consider tapping into your emergency fund instead of pulling money out of your 401(k). The potential interest you would lose from tapping into your emergency fund will generally be lower than the amount of interest you would lose from borrowing against your 401(k). 

How to prevent the need for a 401(k) loan in the future

Unexpected life events and expenses happen to us all. However, the budgeting and saving habits established throughout the years can help you better prepare for these events. 

Here are a few resources on building better saving, budgeting and money management habits:

• Creative Budgeting Strategies You Can Try Now
• How to Manage Your Money
• Emergency Fund: What It Is and How to Build One