401K Loan Overview: Should you Borrow from your 401K?

401K Loans are Becoming More Popular. Should you Borrow from your 401K?

Here’s a fact that may surprise you – 17.6% of Americans with a 401K have an outstanding 401K loan. That doesn’t include the many with closed loans. That’s far more than I would have guessed, given the inherent dangers associated with raiding your retirement account. It left me wondering if there is some kind of 401K loan secret sauce I never knew about that could override the negatives of borrowing from a 401K.

Is there ever a case when you should borrow from a 401K? Is borrowing from your 401K crazy foolish, financially savvy, or somewhere in between? I wanted to test my assumptions. So I tried to find out everything I could about 401K loans, break down the details, and share an overview with you here.

If you have a 401K, you probably have the ability to take out a 401K loan. 401K loans are surprisingly prevalent. Not every employer 401K plan offers a loan option, but most do. In fact, 94% of mid and large-sized employers allow loans on contributions employees have made to their 401K account, while 73% allow loans on contributions the employer has made.

However, just because you can do something, doesn’t mean you should. Rarely is that more apparent than with 401K loans.

What is a 401K Loan?

A 401K loan is as intuitive as it sounds – you are lending money to yourself from your 401K plan balance. Your 401K account is the lender, you are the borrower, and your administrator is the intermediary. If your 401K plan administrator allows the loan, once it is approved, you receive the funds and begin paying them back (with interest) to your 401K plan.

401K loan

What’s unique about 401K loans is that there is no credit check and the interest you pay back goes to your 401K plan, not the financial institution. Payments are typically done automatically through payroll deductions. And you keep paying until the loan is paid in full. If you don’t meet your payments, there are tax implications.

How do you Take Out a 401K Loan?

This is a knowledge share, not an endorsement, by any means. Borrowing from your 401K is relatively easy to do, if your plan has the option. This largely (and unfortunately) is what makes them so appealing.

To find out more, contact your plan administrator by phone or log into your account online. With Vanguard, for example, you can log into your personal account and click on the link to “manage loans/withdrawals”, click a few buttons, and you’re on your way to taking out a 401K loan. Shockingly easy.

401K Loan Terms and Provisions:

401K loans have varying terms and provisions as set by the plan administrator:

401K loan minimum: varies, but $1,000 is common
401K loan origination or application fee: varies, but $25-$50 is common
401K loan annual maintenance fees: varies, but $40-$50 is common
401K loan interest rates: interest rate is often set as the prime rate plus 1-2%. The loans use a fixed rate and will be set on the day the loan is issued.

However, some 401K loan terms and provisions are set by the IRS:

401K loan maximum amount: the IRS limits 401K loan amounts to (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.
401K loan repayment periods: Repayment of personal loans must occur within 5 years. Repayment for loans used for the purchase of primary residence can be more than five years (note: this can vary, but is commonly 15 years in most plans and often requires additional documentation).
401K loan payments: must be made in substantially equal payments that include principal and interest and that are paid at least quarterly. Loan repayments are not considered 401K contributions.

401K Loan Pros

401K loans are popular because they do offer some pretty attractive benefits to borrowers that can make them an attractive and easy option for those who need an influx of capital.

Credit is not needed to obtain the loan: This is a big pro for those who otherwise would have trouble accessing a loan, either due to poor credit history (if you’re not familiar with your credit score or credit report, check out my Credit Karma review to find out how to access them for free) or a lack of credit history.
No hard credit inquiry: With no credit needed, 401K loans don’t require a credit inquiry check, which can have a negative impact on your credit score.
Ease of access: There is very little documentation to fill out and most loans are issued regardless of your needs or reason for taking out the loan.
Low fees: 401K loan fees are low, particularly in comparison to other types of loans.
You pay yourself the interest: There is something appealing about paying yourself interest instead of paying a bank. When viewed in full, the numbers don’t work out to your favor, but it’s an effective mind trick.

401K Loan Cons

401K loans do have benefits, but they have a number of huge cons as well. The disadvantages, while similar in quantity, are much higher impact.

You’re robbing from your future self: in order to pay for today. While you are paying yourself back (hopefully), you are missing out on the power of compound investment returns that your retirement could be reaping. This 401K loan calculator can show you just how much that might become over the years.
Double taxation: 401K loan repayments are being made with after-tax dollars and are not tax deductible. At the same time, distributions in retirement are also taxed. That means you will pay income taxes on the same money twice. This is a huge downside to 401K loans.
Huge default risks: If you don’t make a payment within 90 days, you are in default and defaults are treated as an early withdrawal distribution. This means your withdrawal money is considered taxable income. Even worse, you must also pay a 10% additional tax early withdrawal penalty if you’re under age 59.5.
Stress of job security: What happens to your 401K loan if you quit your job or get fired? In most cases, you only have 60 days to pay the outstanding balance of your loan. Any that you do not repay is considered in default. These are taxes and penalties you probably don’t have the money to cover, if you’re taking out the 401K loan to begin with. That’s a whole lot of risk, which can bring a lot of stress with it and make you feel tied down. There’s no such thing as a free lunch when it comes to 401K loans.
You’re probably not contributing to a 401K: while you’re having funds deducted from your payroll to pay back a 401K loan. This means you’re missing out on additional contributions and any associated employer matching 401K contributions.

Alternatives to 401K Loans

Those are some pretty frightening downsides. Are there alternatives to 401K loans for folks in bad financial situations? Absolutely. Here are a few to consider:

Emergency fund or other after-tax assets: If you have an after-tax emergency savings fund or other after tax savings or assets (i.e. CDs, saving deposits, mutual funds, bonds, personal property you don’t need), raid them first. The big benefit of 401Ks are their tax-saving properties. In borrowing from your 401K, you are throwing that benefit out the window.
Cut your expenses: If you aren’t eating beans and rice, have no car, a tiny apartment/home, and cut all budget towards wants to nothing, then you haven’t done enough to avoid taking out a 401K loan. Emergency only.
Refinance your debt: your debt is negotiable. One thing lenders like less than lower interest rates is defaults. Therefore, they are usually willing to work with you. You could also consolidate your debts at lower rates.
IRS early withdrawal hardship and exceptions: exceptions are are hard to come by, but they are worth looking at, if you need to.

Final Thoughts: Are 401K Loans Worth the Risk?

In my opinion, 401K loans should be looked at like a final financial lifeline – for use in dire financial emergencies only. There are many better alternatives and only a few worse (i.e. payday loans).

Here’s the thing – if you’re in a good enough situation that you don’t need the loan, then don’t take it. Keep that money invested in your retirement and working for you over time. If you’re in a bad enough financial position that you need to take a 401K loan out to stay afloat, the odds are likely not in your favor to pay it back in full. And if you don’t, you’ve robbed your financial future and you are looking at a 10% IRS taxation penalty. If you think missing loan payments to a creditor is bad (it is), not paying back the IRS for taxes owed is significantly worse.

Related Posts: