401(k) Loan: How It Works and How To Get One
A 401(k) is an employer-sponsored retirement plan that allows people to save from their paychecks. A 401(k) plan can help you retire comfortably, but you can also borrow from it before you retire. Here’s what you need to know about how a 401(k) loan works, how much you can borrow and what happens if you change jobs.
What is a 401(k) loan?
A 401(k) loan involves borrowing money from your retirement savings plan. It may be a good option for bad credit borrowers since approval doesn’t depend on your credit score.
The amount you can borrow with a 401(k) loan depends on the balance of your account. The time you have to repay the loan depends on how you plan to use the money and how long you stay at your current job.
Retirement plans typically charge the current prime rate plus 1% to 2% interest rate on 401(k) loans. Since the interest rate on your 401(k) loan goes back into your 401(k) plan, it’s similar to paying yourself back, but with post-tax funds.
How does a 401(k) loan work?
To be approved for a loan from your 401(k), you’ll need to follow several guidelines. Not all 401(k) plans allow you to borrow from your account, so be sure to check with the company managing your funds first. Here’s what you need to know:
- Loan amounts: You can either borrow $50,000 or half of the vested account balance — whichever is less. However, if 50% of the account balance is smaller than $10,000, the borrower can take out up to $10,000.
- Loan terms: Typically, you have five years to repay a 401(k) loan. An exception to this, however, is using your 401(k) to pay for a home.
- Spousal approval: It’s not unusual for both partners to be involved when it comes to spousal debt, and 401(k) loans are no different. Your spouse may need to provide written consent if you plan to take out a 401(k) loan over $5,000.
- Tax implications: If you can’t keep up with payments, your loan will be considered a distribution, which can be taxable. This can result in a big bill when you file your taxes.
401(k) loan vs. 401(k) withdrawal
Taking out a loan isn’t the only way you can access the money in your 401(k) account. You can also make a 401(k) withdrawal, like a hardship withdrawal. The IRS specifies that a hardship distribution can only be used toward an “immediate and heavy financial need” and must be limited to a “necessary” amount, otherwise it’s taxable.
While you’re not required to repay a 401(k) withdrawal, how the money can be used when it comes to hardship distribution is limited. Here are the ways you’re allowed to use your 401(k) hardship withdrawal funds:
- Avoiding eviction or foreclosure on your home
- Medical bills
- Funeral costs
- Home improvements to your principal residence
- Buying a home
- Post-secondary education expenses
Pros and cons of 401(k) loans
You’re paying yourself back on interest
401(k) loans generally don’t come with taxes and penalties, unlike a 401(k) withdrawal
If you can’t repay the loan, it won’t be reported to the credit bureaus or impact your credit score
You’ll lose investment gains while the money you borrowed is out of your 401(k)
If you can’t repay the loan, you’ll owe taxes and a penalty
If you leave your job, you may have to repay the loan immediately or within a short window of time
How does a 401(k) loan work if you change jobs?
If you take out a 401(k) loan and switch jobs, you could be putting yourself in a tight financial position. Most 401(k) plans require that you immediately repay the unpaid balance in full. Some companies provide a short grace period.
If you don’t pay off your 401(k) loan before the deadline, the remaining money in your 401(k) may be seized in what’s known as a loan offset, which wipes out your remaining debt. Since loan offsets are considered taxable, you’ll have to pay an income tax on the amount and a 10% early distribution penalty. If your new 401(k) workplace account accepts rollovers, your loan offset can be moved into that new plan which can help you avoid the tax implications.
Alternatives to borrowing from a 401(k)
The cost of a 401(k) loan can add up. Aside from that, saving for retirement is a long-term goal that could be upended by a short-term problem if you borrow against it. If you’re not comfortable taking money out of your retirement plan, consider these other options:
- Use your health savings account (HSA). If the reason you need a 401(k) loan is because of medical expenses, cover those costs with your HSA if you have one. This type of plan is a kind of savings account that allows you to contribute money from your paychecks — untaxed — to pay for certain medical bills.
- Withdraw from your emergency fund. You started your emergency fund for exactly this purpose: to cover unexpected bills and avoid taking on debt. Using your emergency fund instead of borrowing from a 401(k) will save you money on interest, penalties and taxes.
- Apply for a low-interest credit card. Some creditors offer 0% intro APR credit cards to qualified consumers. These types of credit cards allow you to avoid paying interest for an introductory period, which can last as long as 21 months in some cases. Be sure to pay off the card before the 0% APR window closes or you’ll have to pay interest on the leftover balance.
- Tap into non-retirement accounts. Consider dipping into your other banking accounts such as your checking, savings and brokerage accounts. This approach can help you avoid expensive fees and interest rates.
- Get a personal loan. Personal loans can be used for a variety of purposes, including covering a large expense. This option may be best for those with excellent credit since personal loans are typically unsecured debt and may come with high interest rates if your credit isn’t robust.
- Find a home equity loan or line of credit. If you own a home, you may be able to access funding via a home equity loan or home equity line of credit (HELOC). This option may be good for those planning to make improvements to their property. However, these types of debts are secured by your home — if you don’t keep up with payments, you could lose your home.
- Withdraw from a Roth IRA. If you have a Roth IRA, you can withdraw your past contributions at any time without penalty. As for withdrawing any earnings, you may be charged fees or taxes unless you can prove a qualifying event. Like borrowing from your 401(k), taking money from your Roth IRA will make you miss crucial time growing your retirement funds, so consider this option carefully.
- Lower your 401(k) contributions. To give yourself some extra wiggle room in your budget, you can lower the amount of money you’re contributing each paycheck to your 401(k) plan. This could make it easier for you to save up and afford unexpected bills. Don’t forget to eventually increase your contribution again if possible.