If you're in a financial bind, taking out a loan from your retirement account may seem like the perfect solution. However, it's important to understand the pros and cons of borrowing from 401(k) plans before proceeding. The more you know about how these loans affect your finances, the more equipped you'll be to make the right decision.
The basics of 401(k) loans
According to consulting firm Deloitte, roughly
If you borrow from your account, you typically have to pay yourself back through quarterly payments over a five-year period. Some plans extend that to 25 years if the money is used to
That said, there's a big incentive to make those payments in a timely manner. Any quarterly amounts that are overdue are subject to income tax.
In addition to the principal amount, you're also charged interest. The rate is pretty competitive—typically a percentage point above the prime rate. That's significantly lower than what customers usually pay on a credit card or even a personal loan. And, crucially, that interest goes into your account rather than a bank.
Pros of borrowing from 401(k)
When money gets tight, you may start to wonder, "Should I borrow from my 401(k)?" Compared to other ways of accessing cash—like taking a
- There's no early withdrawal penalty or tax hit. Unlike hardship withdrawals, younger workers generally don't have to worry about paying income taxes on a 401(k) loan or the harsh 10% early withdrawal penalty, assuming that you make your scheduled payments on time.
- You pay interest to yourself, not a bank. The interest assessed on 401(k) loans is low compared to other forms of borrowing. And because you pay that interest to yourself, it's helping to build your retirement balance back up again.
- There's no credit check required. When you apply for a bank loan, they typically assess your creditworthiness. If your credit history is less than stellar, they can use that information to charge you a higher rate or reject your loan outright. By contrast, borrowing from your retirement account does not require running a credit report.
- A default on your loan does not hurt your credit score. Usually, payment information on a traditional loan will end up on your credit reports. That means, your
credit scorecan drop significantly if you owe a large balance or you miss any payments.Payments on your 401(k) are not reported by a lender, so they don't end up on your credit report.
Cons of borrowing from 401(k)
The lack of a credit check beforehand certainly makes retirement plan loans a relatively easy way to access funds. But that's all the more reason to understand the potential drawbacks of these loans, too. Here are some of the factors you'll want to consider:
- Some borrowers may not be able to afford their payments. If the reason you're taking money from your 401(k) is because of financial hardship, a loan might seem like a convenient safety net. But unless you're confident you can repay the loan—which you typically must do within five years—you could make things worse for yourself. Any money you don't pay back on time is subject to income taxes plus the 10% penalty if you're younger than 59 1/2.
- Leaving your job can put you at risk. Some plans require workers to repay loans once their employment has ended. If you're planning to take out a substantial amount of cash, that's a possibility you need to think through. Research indicates that a staggering
86% of workers who change jobswith an outstanding 401(k) loan end up defaulting on their loans.
- You're losing out on potential market gains. The money you pull out of your retirement account isn't being invested, so you're missing the opportunity for that money to grow over time. Because the interest going back into your account is relatively low, it may not make up for lost returns on your stock and bond assets. Therefore, even if you're able to pay the loan back, you could end up with fewer assets in retirement.
- You face double taxation. Contributions to a traditional 401(k) don't count as taxable income. But that's not the case for the money you use to repay your loan. By borrowing, you're nullifying some of the tax advantages of these accounts. The same is true if you own a Roth retirement account, where you contribute post-tax money but have the potential for tax-free withdrawals after 59 1/2. When you take a loan, it is withdrawn tax free, however, you are making the loan payments with post tax dollars. So, you face double taxation on the same net contribution amount as it will be taxable when you withdraw the funds in the future.
Alternatives to a 401(k) loan
Often, the best solution to a cash crunch is to minimize your expenses so you don't need a loan. That could mean moving into a more affordable home, for example, or trading in your current car for a less pricey model. If borrowing becomes a necessity, however, 401(k) loans aren't your only option. Here are some alternative sources of funds that you may want to look at:
- Home equity loans. Loans that are backed by collateral—in this case, the equity in your home—typically offer lower interest rates than other forms of borrowing. You may be able to receive a lump sum of cash or a home equity line of credit from which you draw money as needed. Both types require you to pay
closing costs of around 2%–5% of the home's value,so they make more sense for larger loan amounts.
- Personal loans. If you don't own a home or want to pay closing costs, a personal loan from a bank or credit union is another possible route. Typically, the interest rate is based on your credit score, annual income and amount of existing debt.
- New credit cards. Credit card issuers frequently offer a 0% introductory interest rate to entice new users. Therefore, signing up for a new card can be a good way to free up some cash in your budget. But this strategy only makes sense if you have a solid plan to pay down the card balance before the introductory period is over—
typically in 15–18 months.After that, you'll start getting charged the normal rate, which tends to be much higher than other loans.
Take careful consideration
If you're in need of some extra cash, you should carefully consider the pros and cons of borrowing from 401(k) plans before moving forward. Retirement plan loans can help you avoid the immediate tax hit of a hardship withdrawal, but they ultimately force you to pay more tax on your contributions. In the end, you could lose out on potential investment returns as well.