What Is a 401(k) Loan? Pros, Cons, Strategy

If you are faced with an unforeseen situation such as a sudden job layoff, a medical emergency, or an unexpected debt, you may want to consider taking out a loan from your 401(k) plan. However, contemplate the decision carefully because borrowing against your 401(k) can have serious implications.

Here’s what you need to know about the advantages and drawbacks of tapping into your 401(k) retirement account. You can also contact experts at Empower for a professional opinion.

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What is a 401(k) loan?

According to Jennifer Bellis, a private wealth advisor for U.S. Bank Private Wealth Management, a 401(k) loan is a loan you take against your own 401(k), which is an employer-sponsored, qualified retirement plan.

A 401(k) plan allows employees to contribute pretax dollars to a retirement account. Contributions, often with an employer match, can grow on a tax-deferred basis until you reach retirement.

“It’s a very powerful savings tool and whenever possible, you should take advantage of the benefits of this type of account,” says Bellis. “Taking a loan against it is almost never a good idea and should only be considered when you have no other options.”

401(k) loan pros and cons

Advantages of 401(k) loans

• Minimal fees. Not only are fees generally minimal; there are no prepayment penalties, so you can make a lump-sum payment and pay it back early, making it a good, inexpensive option for a short-term bridge loan.
• Lower interest rate. The interest rate on a 401(k) loan is usually lower than the rate on a personal loan or credit card, especially if you have bad credit.
• Accessibility. A 401(k)f loan is an easily accessible solution to short-term liquidity needs. Unlike an early distribution, you won’t get hit with a 10% penalty or any income taxes as long as you pay it back on time and according to the terms of your loan.
• Flexible repayment terms. The repayment schedule can be more flexible, and although you’re paying interest, it’s to yourself and not a financial institution.

Disadvantages of 401(k) loans

• Significant fees. Some 401(k) loans have origination, monthly, or annual service fees. Fee amounts vary by the plan sponsor, so make sure you understand the terms.
• Negative portfolio impact. By withdrawing money from your 401(k) prior to retirement, you’re missing out on tax-deferred, compounding growth.
• Borrowing limits. There are limits on how much you can borrow against your 401(k). The maximum amount is the greater of $10,000 or 50% of your vested account balance or $50,000, whichever is less.
• Potential default penalties. If you don’t repay the loan as per the loan terms, any unpaid amounts become plan distributions. In that case, the distributions will be taxed as ordinary income, and you’ll get hit with a 10% penalty if you are under 59½ years old.

When should you borrow from your 401(k) plan?

For a house down payment

One instance where it might be worthwhile to borrow from your 401(k) plan is for the down payment on a home. “A home is an appreciating asset, and, like your investment account, its value should grow over time. If you manage it right, your home is like a voluntary forced savings,” says Bellis.

As your home appreciates and you pay down your mortgage, you’re building your wealth through equity. “As long as you’re paying your loan back according to the terms of your loan, which is the same as paying yourself back, you’re now contributing to two savings vehicles instead of one,” she says.

For a short-term bridge loan

Another smart use of a 401(k) loan is for a short-term bridge loan, says Bellis. She provides the following example:

If you’re in sales and have a large commission check coming but need immediate cash, you could take out a loan against your 401(k) and pay it back as soon as your check arrives. Remember that you must make sure you’re making timely payments until you can pay in full, or your loan will be deemed a distribution and taxed as ordinary income, with penalties assessed if you’re under 59½.

When should you avoid a 401(k) loan?

Never borrow for discretionary outlays

Your 401(k) is your retirement savings plan, so you want to let it grow whenever possible. Bad budgeting is not a good reason to take a loan against your 401(k). It shouldn’t be used to subsidize your income, and you don’t want to use it for discretionary items, such as a vacation. Even a car, which is often necessary, is a depreciating asset and not the best reason to borrow against your 401(k).

Don’t borrow if you plan to quit your job

If you plan to separate from your employer, you should avoid taking a loan against your 401(k). Most plan sponsors require your 401(k) loan to be paid back before you leave your job. If not, you’ll most likely get hit with a taxable distribution.

Calculating what you will owe back to your 401(k)

According to Bellis, your loan payment will be based on the interest rate, loan amount, and loan term. The interest rate is typically some spread above the prime rate, which is 8.5% as of March 11, 2024.

For example, if the spread is 1.5%, your interest rate would be 10%. If you borrowed $10,000 over five years and paid it monthly until paid in full, you would pay 60 monthly payments of $212.47 for a total of $12,748.23 or $10,000 in principal and $2,748.23 in interest. “You can reduce your total interest paid if you pay your loan off sooner,” says Bellis. “To understand these numbers, you can use an online amortization calculator.”

TIME Stamped: A 401(k) loan can be useful under the right circumstances but beware of the pitfalls

The decision to borrow from your 401(k) should not be taken lightly. Your 401(k) is designed to be used for your living expenses when you retire, and if you tap into it prematurely, you risk reducing the amount of money that will be available to you in retirement.

Some financial experts say that a significant purchase, such as a home down payment or a medical emergency, may warrant borrowing from your 401(k). However, before you do so, consider other loan sources, such as a personal loan or asking friends and family for financial help.

If you must take out a 401(k) loan, make sure to do all of the following:

• Only borrow the amount you need.
• Make all loan payments on time and in full.
• Continue to save for retirement.

Frequently asked questions (FAQs)

What are some alternatives to borrowing from a 401(k)?

Janine Sam, a financial planner with Empower, says that depending on your financial need, there are many borrowing options that may be a better fit. You might take out a personal loan through your bank or credit union. If you own a house, you could access a home equity loan or line of credit (HELOC). It may also be worthwhile to contact close family and friends if you are comfortable asking for their financial assistance.

Empower Financial Advisor

View Offer

Empower Financial Advisor

Fees

0.89% or less

Account minimum

$100,000

Assets under Management

$1.3 trillion

Accounts offered

Empower Personal Cash, budgeting tool, personalized retirement portfolios, wealth advisory

How can you repay your 401(k)?

To repay a 401(k) loan, be sure to review the loan terms with your employer, says Sam. “Most 401(k) loans come with a five-year time frame for repayment (unless it’s for a house purchase) and occur through payroll deductions.”

Does a 401(k) loan have an impact on your portfolio?

Taking a 401(k) loan reduces the amount of money in your investment portfolio, reducing potential gains a portfolio might have generated had the funds remained invested in the market.