Looking for a fast and easy way to finance an upcoming purchase? A 401k loan is one of the most readily accessible forms of financing for diligent investors who have lots of cash socked away for retirement.
The term "loan" can be a bit misleading. Unlike just about every other type of "loan," there is no lender involved with a 401k loan. In fact, it doesn't even require a credit check. With a 401k loan, you're borrowing from yourself and repayments (with interest) are all paid right back into your employer-sponsored or Solo 401k plan.
Because of its unique features, a 401k loan can be one of the most expedient ways to cover a large expense or consolidate debt. But it could also harm your future self. Are the tradeoffs worth it? We explain the good, bad and ugly when it comes to 401k loans.
401k Loans Vs. 401k Withdrawals
Before getting into the good, bad, and ugly of 401k loans, it's important to understand how a 401k loan differs from a 401k withdrawal.
What Is A 401k Loan?
401k loans are loans that you make to yourself. You borrow against your 401(k), pay interest to yourself, and repay yourself over time (usually over five years). The funds you loan yourself are taken out of investments during the loan period.
However, as you pay yourself back, the funds are reinvested. You can borrow up to $50,000 or half the amount you have vested in the account. To guarantee that your loan gets repaid, employers often allow you to repay loans through payroll deductions.
Note: your employer does have to allow loans for your 401(k). Most allow it, but some do not. If you have a solo 401(k), it's an option that you have to create for yourself - it's not allowed by all solo 401(k) providers.
What Is A 401k Withdrawal?
By contrast, a withdrawal means you take money out of your account with no plan to pay it back. This would typically happen when you're in retirement. When you withdraw money from your 401k, you must pay income tax on the money. Plus, you'll typically have to pay a 10% penalty if you’re under age 59 ½.
There are some exceptions to the withdrawal rules and penalties listed above. First-time home buyers can withdraw up to half of their account balance or $50,000 (whichever is less) for a down payment on a home without penalty. However, taxes will still be due on the withdrawn amount.
On March 27th, 2020, the COVID-19 stimulus package (CARES) made it allowable for investors to withdraw up to $100,000 from accounts without paying the 10% penalty. Investors can also pay the taxes over three years or repay the withdrawal to a 401k or IRA to avoid paying taxes.
The Good Of 401k Loans: When Borrowing Against Your Future Self Could Be Worth Considering
For many people, especially those dedicated to investing for retirement, a 401k loan could be a useful tool. With reasonable repayment terms, and modest rates (generally ranging from 5-8%), the 401k repayment plan is tough to beat.
Plus, 401k loans are typically easy to access. With minimal paperwork, you can take out the loan against yourself. Because of the reasonable borrowing terms, 401(k) loans can make sense in a few circumstances. Here are a few reasons to consider them.
“Oversaved” For Retirement
When you learn about the benefits of a 401k, you may start to stuff all your extra cash in the account. But that may lead you to be cash-strapped when you need to buy a vehicle, a house, or pay for further education. If you’re ahead of schedule on retirement savings and you need some cash today, a 401k loan can make a lot of sense.
Topping Off A Down Payment
If you're buying a house and you need a little extra cash to hit your down payment, a 401k loan could push you over the top. Yes, 401k withdrawals used for a home down payment are already penalty-free. But you'll still need to pay taxes on the amount that you withdraw.
With a 401k loan, you can avoid this tax hit. So as long as you can repay it in five years or less, a 401k loan could help you get into your dream home sooner.
A 401(k) loan can make an amazing “bridge” loan when you want to buy a new house before selling your old house. By taking out a 401k loan, you can avoid PMI and give yourself time to spruce up the old house before selling.
Rental property investors might also use 401k loans to put a down payment on an investment property. Once the property is in place, they can take out a different loan to repay the 401k loans.
Pay Off High-Interest Debt
If you’ve run up some credit card debt, and you don’t qualify for a 0% balance transfer card, a 401k loan could be a strong debt consolidation option. Unlike a home equity loan, you wouldn't be putting your home at risk with a 401k loan. And, unlike personal loans, the "interest" on 401k loans are paid to yourself rather than to a lender.
The Bad Of 401k Loans: Drawbacks To Consider
While a 401k loan can help you pay off debt or invest for the future, they aren’t always a great tool. It's still a form of debt and you'll want to be careful with it. In some cases, the 401k loan just simply doesn’t make sense. Here are a few reasons you may want to shy away from it.
- Repayment Is With After-Tax Dollars: When you repay the 401k loan, you’ll be paying with after-tax dollars. You got the tax-break when you put money into the 401k, so you don’t get an additional tax break on repayment.
- No match on repayment: You won’t receive any employer match on the funds you repay.
- May not qualify to contribute to your 401k during repayment: During your repayment period, you may not be allowed to make pre-tax contributions to the account. That means you miss out on the tax-break and the employer match.
- Lose time in the market: When you take out a 401(k) loan, your money is no longer invested. Instead, the only return you make is the return you pay yourself. For the most powerful compounding effects, you want to keep as much money in the market as you can.
The Ugly Of 401k Loans: When Things Can Go Off The Rails
For the most part, 401k loans are a bit like any loan. You need to be careful or you could end up in serious financial trouble. But there is is one key thing that sets them apart from other forms of debt.
401k loans are tied to your specific employer at a specific moment in time. That means that your loan can go sideways in a hurry. Here are a few ways that a 401k can really fly off the rails.
You Lose Or Leave a Job
When you lose or leave a job, your loan becomes due. You have until your tax filing deadline (April 15th of the following year) to repay the loan. If the money is tied up in something like real estate, getting the money out in time can be a major challenge.
If you cannot repay the loan on time, you’ll have to pay income tax and a 10% withdrawal penalty on the outstanding amount. If you’re facing that situation, do your best to pay off as much as you can before the tax filing deadline to minimize your taxes and penalties.
You Treat Your 401k Like A Revolving Line Of Credit Or An Emergency Fund
A 401k can be a useful place to access cash for short-term investments or to pay off a high-interest debt. But it isn’t a savings account and it isn’t a credit card.
Most of the time, you want to keep as much money invested as possible. If you continue taking out 401k loans over and over again, you’re probably hurting your future self. Try to figure out ways to address your spending and/or income to avoid abusing these loans.
You Can’t Pay Back Your Loan
In most cases, if you had the discipline to save up a 401k balance, you'll also have the discipline to pay back a 401k loan. But if your income or expenses change dramatically, repaying the loan could become a challenge. Borrowers who can’t repay the loan face the full taxes and penalties outlined above for regular 401k withdrawals.
This can be especially hard if you've spend the money, and then get a big tax bill the following year as a result. Will you be able to afford the taxes, or will you also have to just end up setting up an IRS payment plan to pay your taxes?
As a saver and investor, it’s important to take care of your investments. In a lot of cases, that means protecting your investments from yourself. While 401k loans can be helpful, investors (and would be borrowers) should carefully consider their options. Ideally, you’ll want to save for short and mid-term needs outside of your 401k, so you can keep your retirement funds invested for retirement.
If you don't want to pull your 401k funds out of your investments, but desperately need some cash, there are other options to consider. For debt consolidation, a 0% balance transfer card could be a great way to get a 12-to-18-month interest reprieve on your credit card debts. Or if you need to cover an emergency expense, unsecured personal loans tend to offer much lower interest rates than credit cards.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him here and here.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.