401(k) Loan vs. Withdrawal: How To Avoid Costly Mistakes
If you have a 401(k), you may be able to borrow from your retirement savings with a 401(k) loan. You’ll pay yourself back over time, plus interest, and a credit check isn’t typically required.
Still, taking a 401(k) loan is serious business. It puts your retirement savings at risk and can slow investment growth. And, in some circumstances, you might also be subject to taxes and penalties. Learn how 401(k) loans work, so you can make an informed choice.
- There are two ways you may be able to access your 401(k) early: by taking out a 401(k) loan or by withdrawing funds.
- The interest you pay on your 401(k) loan goes back into your 401(k) account. However, taking money out of your retirement account means less investment growth.
- You don’t have to pay withdrawals back, but they’re taxed and may come with a 10% penalty.
What is a 401(k) loan?
A 401(k) loan involves borrowing money from your employee- or self-sponsored 401(k) account. It may be a good option for bad credit borrowers, since approval doesn’t depend on your credit score. Instead, whether or not you can get a 401(k) will depend on whether your plan allows them.
As long as you repay your 401(k) loan on time, you won’t owe taxes or early withdrawal penalties, even if you’re younger than 59 ½ (the age you’re allowed to tap into your 401(k), penalty-free).
How does a 401(k) loan work?
A 401(k) loan works differently than other types of loans. Rather than getting the money from a lender or loan company, you’ll borrow it from your 401(k) or 403(b) account. Loans are not allowed on IRAs.
When you repay your 401(k) loan, the funds will go back into your 401(k) account. 401(k) loans come with interest, but the interest you repay also goes back into your retirement account.
In the short term, 401(k) loans can be a cheaper way to borrow than other types of loans — you’re paying yourself back interest, not a lender. Rates also tend to be lower, generally.
But in the long term, you’ll need to consider the impact a 401(k) loan can have regarding your retirement plans. Even if you’re far away from retirement age, money out of the market is money that’s no longer growing.
Credit checks aren’t usually required to get a 401(k) loan, and 401(k) loans shouldn’t affect credit scores. However, loans will have to meet certain conditions.
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Loan amounts: Borrow up to $50,000 or 50% of your vested balance
, whichever amount is smaller. If your vested balance is under $10,000, some plans may only allow up to $10,000.Your vested balance is the 401(k) balance that you can keep, even if you leave your job. You always own 100% of what you contribute, but may need to work at your job for a certain length of time before you fully own employer contributions.
- Loan terms: Typically, you have five years to repay a 401(k) loan unless you’re using your 401(k) to pay for a home. (In that case, you could have a loan term of up to 10 years.) Keep in mind that if you leave your job, many 401(k) loans from an active plan have to be repaid immediately.
- Spousal approval: Your spouse may need to provide written consent before you can borrow — it all depends on your specific plan provisions.
Interest rate on a 401(k) loan is typically 1% to 2%, plus the prime rate. The prime rate is the lowest rate that most banks are currently charging their most creditworthy customers, and it often fluctuates.
You can check the prime rate in The Wall Street Journal (see “U.S.” under “International Rates).” However, you should still ask your retirement plan provider for more information, as it sets how much it charges above the prime rate.
How does a 401(k) loan work if you change jobs?
If you take out a 401(k) loan and switch jobs (voluntarily or not), you could be putting yourself in a tight financial position.
When you leave a job with an outstanding 401(k) loan, your plan may require you to pay off the whole loan balance in a short amount of time.
If you don’t pay the balance within the plan’s allowed grace period, the IRS may treat the unpaid amount as a “deemed distribution.” This means that it can be reported as taxable income, and may also be subject to an early withdrawal penalty if you’re under 59 ½.
In contrast, a “loan offset” happens when the plan closes out the loan by taking out what you owe from your 401(k). Whether your unpaid 401(k) loan is eligible for offset will depend on your employer’s plan rules.
Timelines and rules vary by plan, so check your plan’s loan policy regarding employment changes before taking a 401(k) loan.
Ask LendingTree: What should you understand before borrowing from your 401(k)?
A 401(k) loan can seem like a quick fix, but it comes with a significant long-term trade off: The borrowed funds are no longer invested in the market, which can be a setback for your retirement savings.
For this reason, it’s often wise to consider alternatives, like tapping your emergency fund or using a personal loan, before turning to your 401(k).
Retirement considerations of 401(k) loans
It can be hard thinking so far in advance when you need a quick loan, but it’s important to consider the opportunity costs that can come with 401(k) loans, or the growth you can miss by borrowing against your retirement.
- Money you borrow won’t grow until you pay it back. Until you do, you’ll lose future compounding on that amount.
- You might miss out on high growth if the market is strong and yielding solid returns, depending on how long it takes to repay your loan.
- An additional loan payment may lead you to cut back on retirement contributions.
- If a 401(k) loan is treated as a distribution or loan offset, that money is no longer invested in your 401(k).
Pros and cons of 401(k) loans
If you haven’t established an emergency fund or have a bad credit score, you may be considering a 401(k) loan. Even though the interest you’ll pay will come back to you rather than get paid to a lender, there are still risks when you borrow from your 401(k).
Pros
- 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
Cons
- 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 possible 10% penalty
- If you leave your job, you may have to repay the loan immediately or within a short window of time
- Can take up to 10 business days to get your money, longer than personal loans or credit cards
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.
You won’t have to repay a 401(k) withdrawal, but your plan has to allow withdrawals in order to get one. Most withdrawals are taxed and come with a 10% penalty if you’re under 59 ½, though some exceptions — like hardship withdrawals — avoid the penalty.
The IRS specifies that a hardship distribution can only be used toward an “immediate and heavy financial need” and as a requirement is limited to a “necessary” amount — otherwise, it’s taxable. Your employer will decide what counts as an “immediate and heavy financial need.”
Under the “safe harbor” rule, the IRS considers all the scenarios below as an “immediate and heavy financial need.” This typically means automatic approval, as far as loan use is concerned. Stipulations apply, so speak to your retirement plan provider for more information.
- Avoiding eviction or foreclosure on your home
- Medical bills
- Funeral costs
- Home repairs to your principal residence
- Buying a home (not including mortgage payments)
- College expenses for the next 12 months, for the employee or certain family members
Alternatives to borrowing from a 401(k)
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 you need a 401(k) loan because of medical expenses, cover those costs with your HSA if you have one. This is a kind of savings account that allows you to contribute money from your paychecks — untaxed — to pay for certain medical bills.
- Use your emergency fund. You started your emergency fund for exactly this purpose: to cover unexpected bills and debt. Using your emergency fund instead of borrowing can save you money on interest, penalties and taxes.
- Apply for a low-interest credit card. Some creditors offer 0% intro APR credit cards to people with good or excellent credit. 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.
- Get a personal loan. Personal loans can be used for a variety of purposes, including covering a large expense. Still, this option may be best for those with excellent credit. Personal loans are typically unsecured debt and usually come with high interest rates if you don’t have at least good credit (670+).
- 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 — and if you don’t keep up with the 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.
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