Things You Should Know About Borrowing from Your 401(k)

401(k) Loans Have Their Advantages and Disadvantages

401k box full of paper money
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Many employers allow their employees to borrow money from their 401(k) plans through what is known as a 401(k) loan. Of those 401(k) participants whose plan offers a loan option, it is estimated that only about 20% have an outstanding loan at any given time. Though many like the idea of borrowing from themselves over borrowing from a financial or banking institution, taking a loan out from your 401(k) is not as simple as it may appear.

Important 401(k) Loan Facts

While many 401(k) plans offer loans, the fact that the option is offered does not mean you should take the first opportunity to use it. In fact, in most cases taking a loan against your 401(k) is not the best solution and as such has been labeled by many as a "last resort". But as is the case with many financial decisions, there are some reasons why borrowing from yourself through a 401(k) loan makes sense.

If you are considering a 401(k) loan, make sure you know the rules and understand the relative advantages and disadvantages of a 401(k) loan before you sign on the dotted line. Before getting started, here are nine things to know about a 401(k) loan (the good, the bad, and the neutral).

1. 401(k) Loans Have Borrowing Limits

In general, you can only borrow the lesser of $50,000 or one-half of your retirement plan balance. To accept the loan, you must typically agree to begin paying back the loan as soon as your next pay period. Most often, this is done through the convenient process of an automatic deduction from your paycheck.

2. 401(k) Loans Have Length Restrictions

Unless you use the money to acquire a home, you must pay the loan back in five years or less. If you borrow the money so you can purchase a residence, the length of the loan may be significantly longer, but be sure to note the risk of termination below.

3. 401(k) Loans Don't Require a Credit Check 

No credit check will be performed if you request a 401(k) loan since you aren’t actually borrowing money. Instead, you are temporarily tapping into your retirement funds. Since no entity is loaning you money, there is no need to check your credit. But that doesn't mean you won't pay interest.

4. 401(k) Loans Have a Competitive Interest Rate

Regardless of your credit score, you’ll pay a competitive interest rate on a 401(k). The rate is often in the neighborhood of the prime rate, which is consistent with typical consumer loans. Better yet, you’ll pay back the loan principal and the interest, to yourself, not to a bank or other financial institution. The entire amount of each loan repayment goes back to your 401(k) account.

5. 401(k) Loans Have Low or No Application Fees

Since a 401(k) loan isn’t a true loan, any application fees are usually minimal. However, if your plan has an origination fee this usually goes to the plan administrator and not back into your account. Many plans charge and origination fee up to $75 per loan. This means that if you borrow $1,000 you could lose 7.5% right away. So it's important to pay attention to the total cost of the loan if there are origination or application fees.

6. 401(k) Loans Result in Lost Investment Growth

Your borrowed 401(k) money will not be invested for your retirement for the entire time the money is outstanding from your 401(k) plan. Therefore, you forgo all potential investment gains from all borrowed funds for the duration of your 401(k) loan. But perhaps most impactful, you lose out on gains from compound interest. So remember, when you borrow from your 401(k), you are borrowing from your future self and even when you pay back the principal and interest, you likely still won't break even in terms of lost investment growth by the time you retire.

7. 401(k) Loans are Repaid with After-Tax Money

Unlike the initial 401(k) contributions which were likely tax deductible, when you pay back your 401(k) loan, you do so with post-tax (or after-tax) dollars. Consequently, a $100 loan repayment reduces your take-home pay by $100. Worse, when you take the money out of your 401(k) plan during retirement, you will pay tax on the same money again. 

8. 401(k) Loan Terms are Dependent on Employment

There is a real risk with 401(k) loans that not many people know, which is the risk of job termination. The reason that termination poses such a risk is that the terms of 401(k) loans are generally tied to your employment status with that employer. No matter the cause, if you cease working with your current employer, the entire remaining balance of the loan will be due by the tax filing deadline (including extensions). Under prior law repayment of 401(k) loans had to occur within 60 days of leaving employment.

While the If you are unable to pay back the loan balance during that quick time frame, the entire amount you are unable to pay is deemed a distribution, which is likely to be subject to significant federal income tax, state income tax, and early distribution penalties.

9. 401(k) Loans are Still Generally Better Than a Distribution

While a 401(k) loan has some benefits, its significant negatives ought to be avoided except during a genuine financial emergency. Most financial planners advise people to act as though their retirement funds are off limits. It is always better to be prepared for a financial emergency with emergency funds or proper insurance. Still, if your only other source of money in a true emergency is an outright distribution of your 401(k) money, a 401(k) loan is still the preferable option. This is due to the fact that unless you are terminated during the life of the loan, you can avoid paying income tax and penalties you would on a distribution.

Just be aware that the convenience of the 401(k) borrowing option has certain consequences to consider.