Takeaways
- 401(k) loans can be an easy source of capital if you have already saved for retirement.
- The maximum 401(k) loan is the lesser of $50,000 or 50% of your vested balance.
- In 2023, over 80% of employer-sponsored 401(k) plans offer access to plan loans.
- Taking out a 401(k) loan can hamper your retirement savings if not paid back quickly.
- Alternatives to taking out 401(k) loans include an emergency fund, personal loan, credit card cash advance, and other short-term financing options.
Are you in a pickle and need some cash quickly? Super retirement savers are in for some good news. Your 401(k) plan could be an untapped well of short-term funding. If you have been making 401(k) plan contributions, and maybe even receiving 401(k) matching contributions, a 401(k) loan could be the solution to your cash crunch. Learning how a 401(k) loan works can help you balance the pros and cons of this financing option to see if it suits your needs.
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What is a 401(k)?
A 401(k) plan is a retirement savings plan offered by certain private and public companies. This employer-sponsored plan is what is known as a defined contribution plan. Employees can contribute pre-taxed income into their 401(k) plan and deduct their contributions from their taxable income during tax filing season. Companies typically offer employees a pre-selected menu of high-quality investments. If you work for a company with a 401(k) plan, you will probably have a buffet of mutual funds, target date funds, and exchange-traded funds to choose from in your retirement plan.
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Contributing to your 401(k) helps increase your net worth and provides a pool of capital to draw on during times of uncertainty. The rules are designed to keep these funds focused on investing rather than acting like a piggy bank. While you could technically liquidate investments and withdraw funds, if you do this before you are 59 and a half years old, you could be subject to a 10% penalty on the amount withdrawn and must pay taxes on those funds [1]. Alternatively, you can access your retirement funds penalty-free by taking out a 401(k) loan.
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How a 401(k) Loan Works
A 401(k) loan allows you to borrow money from your 401(k) plan. Unlike a traditional loan from a bank or credit union, the interest you pay goes back into your 401(k) account, essentially paying yourself back. This type of loan can be appealing because it does not affect your credit score (no credit check), and the loan approval process is straightforward and quick.
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According to recent Vanguard data, over 83% of 401(k) plans under Vanguard management offered loans, and over 12% of employees take advantage of this plan feature [2]. However, taking out a 401(k) loan depends on your company's plan provisions, and not all employers allow plan loans. You can check with your Human Resources department or plan administrator to see if your 401(k) plan provides this option. Most plans allow you to borrow from your plan for almost any purpose, from consolidating debt to covering unexpected expenses or even funding a down payment on a home.
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It is critical to understand that a 401(k) loan is not a disbursement or a withdrawal, and you must repay the borrowed amount in addition to interest within a specified term. Most employer plans require you to repay a loan within five years and make a minimum of quarterly payments. Taking out a loan from your 401(k) should be weighed heavily because it can significantly derail the trajectory of your retirement savings. Failure to repay your 401(k) loan can result in tax implications.
Advantages of Borrowing from Your 401(k)
Borrowing from your 401(k) can be a convenient option to get cash fast under certain circumstances. There are many valid arguments against using plan loans, so analyze the advantages and disadvantages before you pull the trigger on a 401(k) loan. Here are some situations where a 401(k) loan might make sense:
Convenience and Ease of Funding: One of the most significant advantages of a 401(k) loan is the simplicity and speed of obtaining the funds. Since you are borrowing from your retirement savings, there is no need for a credit check or a lengthy application process. Low regulatory hurdles can be particularly helpful in emergencies or when you need quick access to cash.
Low Cost: Generally, the interest rates on a 401(k) loan are lower than those on some personal loans or credit cards. Interest rates on 401(k) loans are 1% - 2% higher than the prime rate. Additionally, the interest you pay on a 401(k) loan goes back into your retirement account. By paying your loan back, you are giving yourself a financial return. This can soften the impact of borrowing from your future savings.
Repayment Flexibility: Repayment terms for a 401(k) loan are often flexible and tailored to suit your financial situation. Typically, repayments are made through payroll deductions, spreading the cost over the term, which makes it easier to manage alongside your other financial commitments.
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Disadvantages of Borrowing from Your 401(k)
While these three situations can make a 401(k) loan very attractive, there are certainly downsides to consider. Here are multiple negatives to borrowing from your 401(k):
Borrowed Capital is Not Invested: The money you borrow is not invested in stocks or bonds until it has been paid back and the repayment period is over. Depending on the loan term, focusing on paying back your 401(k) will distract you from making new contributions to your 401(k) account. This has the potential to set your retirement savings back several years and cost you thousands of dollars in lost capital appreciation.
Lack of Employment Flexibility: The outstanding balance may become due if you are involuntarily terminated or leave your job to get a raise. If you fail to repay your loan, it could be considered a 401(k) distribution, which might be subject to taxes and penalties.
Slowing Retirement Savings: You should weigh the immediate need for funds against the potential long-term impact on your retirement savings. In many cases, it is probably wise for you to exhaust other options before tapping your 401(k). There are a variety of financing options you can consider (more on that below).
Maximum You Can Borrow from 401(k)
When considering a loan from your 401(k), it is important to understand how much you are allowed to borrow. The Internal Revenue Service sets limits on the maximum amount you can take out as a loan from your 401(k) plan. You can borrow up to 50% of your vested account balance or $50,000, whichever is less [3].
However, if your vested account balance is less than $10,000, you may be able to borrow up to $10,000, even if this is more than 50% of your balance. The vested account balance refers to the portion of your 401(k) that you own outright, including your contributions and any employer contributions that have become yours according to the plan's vesting schedule [4].
How Do You Repay a 401(k) Loan?
Repaying a 401(k) loan is typically straightforward but requires a commitment to ensure your retirement savings remain on track. When you take out a 401(k) loan, you agree to repay the borrowed principal plus interest. Most plans allow you to make these repayments through automatic payroll deductions, which can feel hassle-free. This helps ensure repayments are consistent and manageable over the life of the loan.
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If you do not repay the loan according to the agreed terms, the outstanding balance is typically treated as a taxable distribution [3]. This means it could be subject to income tax and, if you are under 59½ years of age, an additional 10% early withdrawal penalty.
7 Alternatives to a 401(k) Loan
Analyzing your access to the best short and long-term financing options should be part of your financial planning process. Whether you are trying to fund the purchase of a new car or need a loan to renovate your house, access to pools of capital is a critical part of preserving personal optionality. Here are seven alternatives to taking out a 401(k) loan:
- Personal Loans can help finance small and large ticket items. Do you have medical bills, a home remodel, or a tax bill that requires cash today? Consider investigating whether a personal loan makes sense for you and your financial situation.
- Credit Card Cash Advances are available to anyone who has a credit card that allows for cash advances. Although credit card cash advances can be capped on the amount you can withdraw, this is certainly an option if you need cash today. But cash advances have high interest rates that begin accruing immediately.
- Emergency Funds hedge against the need to use credit cards and high-cost debt to pay for unforeseen expenses. Cash demands can come out of nowhere, and if you are using your emergency funds for a true emergency, the account is proving its worth.
- Slush Funds are meant to give you enough savings for at least 3 to 6 months of living expenses. Depending on the nature of your capital needs, plucking cash from your slush fund might be appropriate.
- Stock Investments can be liquid enough to sell and convert to cash. Whether you are selling an individual stock or exchange-traded fund investment, it only takes a couple of business days for your online brokerage to settle the transaction and put the funds in your account.
- Bond Investments can also be sold quickly. Although setting up a bond might mean you incur losses on your investment, if access to cash is the paramount concern, this is a viable option.
- Savings Accounts are meant to house money accumulated for the express purpose of paying for a particular goal. Sometimes that savings goal may need to be superseded by an immediate and unforeseen cash demand. You can always replenish a savings account once you tap into your cash.
Smart Summary
Your 401(k) plan offers you many advantages. The first is that you are proactively saving for retirement, and the second is that it provides a pool of cash you can quickly access. A 401(k) loan is a financing option if you have vested funds in your account. These relatively low-cost and shorter-term loans could be the perfect source of capital for your needs but be sure using these funds doesn’t derail your overall financial goals.
(1) Internal Revenue Service. Hardships, Early Withdrawals, and Loans. Last Accessed February 12, 2024.
(2) Vanguard. How America Saves 2023. Last Accessed February 12, 2024.
(3) Internal Revenue Service. Retirement Topics – Plan Loans. Last Accessed February 12, 2024.
(4) Internal Revenue Service. Retirement Topics – Vesting. Last Accessed February 12, 2024.
(5) Internal Revenue Service. Fixing Common Plan Mistakes – Plan Loan Failures and Deemed Distributions. Last Accessed February 12, 2024.
