There comes a time that you may be in an emergency and you may need money immediately. Sometimes, you may have nowhere to go except tap into your retirement plans such as your 401k plan. You may be able to take a 401k loan or 401k hardship withdrawal.
The difference between a loan and a hardship withdrawal is that on loans from 401k, you can pay it back while on a withdrawal, you are not allowed to return the money. In fact, you cannot even make contributions to any retirement plans on a hardship withdrawal for six months, adding more damage to your retirement goals. In addition, proceeds from the loan are not taxed and penalized while with the hardship withdrawals, not only that you have to pay the early withdrawal penalty, the distribution is added to your gross income and gets taxed at your tax rate. On this post, we will be discussing the advantages and disadvantages of taking out a loan from 401k plan.
A few Quick Things To Know About 401k Loan:
- You can take out as much as 50% of the balance up to a maximum of $50,000. For example, your 401k balance is $200,000 but the most you can take out is only $50,000 (and not $100,000 – 50% of $200,000).
- If you have taken out a previous loan, the maximum you can take on the second loan is reduced by the first loan. For example, if you already taken out $25,000 on the first loan, then you can only take $25,000 on the second loan for a maximum aggregate loan amount of $50,000 (assuming that your 401k balance is $100,000 or over when you take out the loan).
- The funds from the loans are not subject to the 10% early withdrawal penalty unless the loan defaults.
- The funds from the loans are not subject to income tax.
- You cannot roll over a 401k loan into an IRA.
- You can always repay the loan at any time with no pre-payment penalties.
- You cannot add additional amount towards the loan. It’s either you make the monthly amount or you pay off the whole outstanding balance.
Advantages of Taking Out a 401k Loan:
Ease of Withdrawal
Taking out a loan from 401k is super easy since you are borrowing your own money. There is no credit check because your retirement is acting as collateral. Normally, when taking out loans, I have to sign loan documents first, even for the ones that have collateral, before banks issue the check. It’s not the case with this one. When I took out my loan, I applied online and two days later, the check arrived. The terms and conditions were attached with the check and by endorsing and cashing the check, I agreed to the terms and conditions of the loans from 401k. I did not have to send anything back to the bank.
Competitive Interest Rates
The interest rates are much better than a personal loan, line of credit, or credit card cash advance. At the time that I took out the loan, the going rate for the personal loan at my credit union was 10%, line of credit is around 7% and credit card cash advance is around 10-15%. The interest rate on the retirement loan is only 4.25%.
Interest Payments Goes To Your Account
When you pay back the loan, all the proceeds goes back to your account including the interest. Remember it is your own money that you are borrowing
Automatic Payroll Deduction for Payment
The payment is done through automatic payroll deduction just like with a contribution so you do not have to worry about writing a check or missing out on the loan.
Flexible Payment Terms
If you are taking out a loan from 401k to use for the purchase of your principal residence, you have up to 15 years to pay it back. If you are taking out a loan for any other reason, you have up to 5 years to pay it back.. However, you cannot do accelerated payments, which is adding more to the principal in order to pay it quicker. It’s either you have to pay the regular monthly amount or you have to pay off the whole balance. When I took out a loan, I did not want to go through the whole 5 years, so I took out the loan for just three years.
Disadvantages of Taking Out a 401k Loan:
Lose the Growth Opportunity
In most cases, you lose the opportunity for growth. With the state of the stock market, I took the chance when I took out the loan. The market was at 10,600 points and a couple of months later it was running at 10,000. In this case, it is a good decision as long as I pay it back. However, if the market is going robust, then taking out a loan from 401k would really hurt your retirement growth. As of the date of this posting, DOW Jones is at 11,400 points after a year of the loan, the decision is questionable since I lose the growth opportunity.
Tax Consequences when leaving the company
Another drawback is that when you no longer work for the employer where you keep your 401k, you have to pay the loans from 401k back immediately. Otherwise, the outstanding loan balance will be reported as distribution and you have to pay taxes on that. Also, if you have not reached 59 ½ years of age, you are also required to pay the 10% penalties for early withdrawal. Lastly, the loan proceeds will be treated as income to you which can potentially put you in a higher tax bracket, thus, paying taxes at a higher rate.
Loan Payments are paid with after-tax dollars
The advantage of a 401k contributions is that the contributions are deducted from your gross income before you get taxed. Not with the loans. You have to use your after-tax money with this one.
What about you, have you taken out loans from 401k plans? What are your experiences?
Photo credit: Millionaire Mindset Secrets
Very informative post … But what if your personal loan is about 13%, your possible 401K is at 4%, your job is stable and you can get rid of that loan in 12 months. Would you do it? I did! It makes me nervous sometimes (losing a job in this economy) but I still did it and so far… it is going well. I love the automatic deductions and I can see how the loan is decreasing monthly. Still nervous and will be till it all paid off.
If the interest rate is high (at 13%), then it is a good idea to take out a retirement loan and pay-off the higher interest credit card.
Depends on what you use the loan for. A down or partial payment on a house or other hard assets, smart idea. A week in Maui with 10 of your best friends, not so much. Also, *all* loans are repaid with after-tax money.
Totally agree on this one. You should only take out a loan if you need important or emergency items such as buying a house, paying off higher interest credit cards or personal loans. It should not be use for frivolous or extravagant expenses such as an exotic vacation.
We took out a loan to buy our first house. I love the idea of paying myself the interest instead of a bank. With the way the market has performed, turned out it wasn’t such a bad idea after all. (It was only for five thousand dollars though.)
I agree with 101 Centavos. If it is for a house, great. Not so great if it is for something frivolous.
I was going to take a loan from my 401k to buy our first house, but my parent convinced me to take a loan from them. I paid 10k and borrowed 30k from my parents. The loan has been paid back and I’m really thankful that I didn’t have to raid my 401k. My plan now is to not touch the 401k until I’m in my 60s.
401k loan should be a last resort and should not be relied upon all the times. It’s good that you did not do it and have gone through other means such as borrowing from your parents.
I had one buddy that tapped this 401k to pay off his credit cards, but he didn’t change this spending habits.
If you have the disipline to pay off the loan, then it’s a good cheap loan. If not, you’re damaging your future nest egg…
Great deal on the pros and cons!
Refinancing huge credit card balance using either the 401k loans or home equity loans would be bad for the debtor who still continues to stay with the old habits of racking out debt. If they file for bankruptcy, the 401k loans are not dischargeable since this is your own money. If the debtor cannot pay the loan, it will just be reported as income on his/her tax return.
This is very dangerous territory for the undisciplined spender. Better for 99% of people to just leave it alone. Buying a house and paying yourself back the interest instead of the bank is the only way I could see justifying it. But then the 4% return on your house loan may not beat your other investment alternatives, and certainly won’t make you rich.
Good point. The return on the house is not that great as oppose to the return that you’ll get from stocks or other investment option. However, if you’re short on your home purchase cost and you have no where else to go, perhaps you can dip just a little bit on your retirement to cover the balance. But an individual should not use a lot of their retirement. The rule makes you not to do it by limiting the amount of the loan to just 50% of your retirement balance but I wouldn’t go that far though and lose the opportunity growth.
I agree with Ken, taking a loan from your 401(k) should be a last resort. Ideally you will be funding an emergency fund as well as saving for retirement. In my opinion both should be factored into your budget.
401k plan should always be the last resort. People should always try to find other resources first before they tap their retirement fund.
Mentally, I feel like 401K money isn’t even real money. Personally, the only people I knew that have tapped theirs were horrible with money management. One guy took out a hardship loan to buy a dodge durango to replace his 2 year old other gas guzzling jeep. He’s going to be eating cat food when he’s in his 70′s…no doubt about it.
That guy took out a hardship loan to buy a car? Wow…not sure about that, I don’t think I can call that an “emergency.” There are just some people who use it for the wrong purpose.
Hi Ken,
Good post! This is the best plain English resources I have seen on the subject.
A question came to mind. Are regular contributions still allowed during the loan payback period? I figured they were but never thought to ask.
Also, I wonder if there has ever been any legal action against an employer terminating an employee with a high loan balance. Not a firing situation but a layoff or downsizing situation. Seems like there would be some sort of grounds for a lawsuit as it could cost the employee thousands of dollars in taxes. Or do you know of a way around the taxes to ease employees into the idea diffusing the problem in advance?
Keith
Hi Dennis,
Thanks for the compliment. Regular contributions are still allowed during the loan pay back period. You may have confused the loan vs the hardship withdrawals. On the hardship withdrawals made against the 401k plan, individuals ARE NOT allowed to make contributions for six months to the 401k plan and ANY retirement plan, including the IRA or Roth IRA.
I’m not sure about the legal action against an employer terminating (laying off) an employee with a high loan balance. It may be hard to justify for the employee that he got laid off because of a high loan balance. Anyways, it may seem ridiculous for the employer to terminate the employee if this is the reason because:
1.) You are borrowing your own money and not the company’s funds
2.) You cannot borrow more than 50% of your 401k plan. There may be a maximum amount that you can borrow but I’m not sure, I may have to research further on that one.
But if can see the financial crisis that the employee may be facing in case he got terminated: he’ll be on the hook to pay taxes and penalties on the outstanding balance on the loan and he may not have the money to pay for those come tax time.
I had to take out a 401K loan 2 years ago. I am 54 and had kidney cancer and was out of work for 2 1/2 months. We went through our savings the first 2 months not including the hospital bills we had to pay. But, I’m paying the loan back as fast as possible since I’m paying it back to myself. I only have 3 months left to pay that back!
I have never ever taken out a 401k loan. But, that was the only alternative for me at that time. Do I recommend you do it too? No, but in an emergency…why not!