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With the rising cost of living making it more difficult to afford everything from groceries and gasoline to housing and health care, you might have thought about borrowing from your 401(k) to cover some of these expenses.
A recent T. Rowe price study found that 401(k) loans have been steadily increasing since 2020, although they still have not reached pre-pandemic levels. The firm noted that loans had decreased at the beginning of the pandemic as the government temporarily eased some restrictions on early withdrawals.
While a loan from your 401(k) can be a quick and secure way to get additional funding, prematurely withdrawing from your retirement savings plan could have severe consequences down the line.
Here are the pros and cons of taking out a 401(k) loan.
See Insider’s picks for the best retirement savings plans >>
How a 401(k) loan works
A 401(k) loan isn’t actually considered a true loan since you’re borrowing the money from your own 401(k). But that comes with significant consequences that may put a strain on your finances in the future.
“A 401(k) loan allows you to borrow money from your 401(k) and pay yourself back with interest,” says Matt Zokai director of retirement solutions at Avantax Wealth Management. “If your plan allows for loans, generally you can borrow the lesser of $50,000 or 50% of your vested account balance, which must be repaid in no more than five years.”
Anyone can take out a 401(k) loan at any time as long as your 401(k) plan allows loans and your plan administrator approves it. Unlike a personal loan, you won’t need approval from a bank nor will you need to get your credit checked.
401(k) loan: Pros and cons
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Advantages of a 401(k) loan
Avoid taxes and penalties
A 401(k) loan is easier and less penalizing compared to a 401(k) hardship withdrawal. With a 401(k) hardship withdrawal, the amount you withdraw is taxed as regular income, plus you’ll be charged a 10% early withdrawal penalty fee.
Money from a 401(k) loan, on the other hand, is not taxed when you take it out, as long as you pay back the loan (and any accrued interest) on time. You also don’t have to claim your 401(k) loan on your tax returns. But keep in mind that the money used to pay off your loan will be after-tax dollars.
Pay interest back to yourself
Unlike a personal loan, you won’t be paying interest payments to a bank. Instead, the interest on your 401(k) loan is paid back to you, into your 401(k) account. Although you’ll be responsible for paying the interest on your loan at the time of payment, you aren’t technically losing that money.
Automated deductions
In the same way that 401(k) contributions can be automatically deducted from your paycheck, your loan payments can also be automatically detected from your take-home pay. Automatic payments are not only convenient but can also help prevent you from accruing interest or missing loan payments.
No credit check or impact on your credit score
Another convenient 401(k) loan beneift is that you won’t have to get a credit check in order to take one out. As long as your 401(k) plan permits loans and your plan administrator approves, there’s no other approvals needed. Also. 401(k) loans typically aren’t reported to the major credit bureaus, so your credit score won’t take a hit.
That also means that you won’t need to deal with the hassle of a loan application. But if you’re married, you may need your spouse’s approval before taking out a loan on your 401(k) loan.
A 401(k) loan may be the preferred option for folks with low to bad credit scores since they don’t have to worry about being turned down or further damaging their credit.
Disadvantages of a 401(k) loan
Funds won’t accrue compound interest
One of the biggest advantages of retirement savings plans like a 401(k) or IRA is the ability to accumulate compound interest over the long term. Even the smallest contributions here and there can significantly grow by the time you retire. So the sooner you start contributing to your retirement savings, the better.
“One of the biggest advantages of investing in a 401(k) is the power of compounding,” says Zokai. “The money you invest in stocks and bonds can earn dividends, interest, and also appreciate in value. Compounding means you are not only earning on the contributions you’ve made, but your earnings are also earning.”
Once the money exits your account, it will no longer accrue interest. Accruing interest on your retirement savings is essential to growing your wealth, but taking out a loan prevents that money from growing with the market. Even if you pay back your loan in a few years (with interest), you still won’t be able to make up for the lost time.
Estimate how much you need to retire with Insider’s retirement calculator >>
You may not be eligible to contribute to your 401(k)
You may not be able to continue contributing to your 401(k) while there’s an outstanding loan. Depending on your plan, you may have to wait years before being able to contribute to your retirement savings again. This means you’ll miss out on the tax advantages of contributing to your 401(k) plan during that time period, as well as possible employer match contributions. You’ll miss out on years of potential compound interest on your earnings.
“The most important part of saving in a retirement plan is starting to contribute,” Zokai says. “That may mean that you can only start with 1%, but you’ve at least begun the process and are potentially even taking advantage of an employer matching contribution.”
You’ll lose tax benefits
You’ll also lose your initial tax benefit as loan payments are made with after-tax dollars. Therefore canceling the advantage of the initial tax break you’d receive with a traditional 401(k) contribution. Plus, you’ll be taxed again when you start withdrawing funds when you reach retirement age.
Loan payments must also be made with after-tax dollars.
No bankruptcy protection
Personal loans are often dischargeable, which means you have protection in the event of bankruptcy. For example, if you have an existing personal loan from a bank or credit union and you go bankrupt, you may be eligible to have your personal loan forgiven.
But 401(k) loans are often not eligible for discharge in bankruptcy. That means if you go bankrupt and have an existing 401(k) loan balance, you’ll still be required to make payments. This may cause you more money and stress in the long run.
Can’t withdraw more than 50% of your vested balance
You can’t withdraw more than half of your vested 401(k) balance even if you’re looking to take out more. The maximum 401(k) loan is currently $50,000 or 50%, whichever is less. You also won’t be able to withdraw non-vested money.
Any money you deposit into your 401(k) plan is owned by you. However, employer-match contributions will technically not be yours until you’ve become vested.
Leaving your job may speed up the repayment schedule
If you leave your current place of employment or get fired, the payment schedule for your loan may be sped up. A 401(k) loan is generally paid back in about five years. But if you change jobs, you’ll might have to pay back your loan sooner. Unless your plan allows you to continue to make payments after your employment ends, you must repay your 401(k) loan balance by the due date for your federal tax return. If you fail to do so, you’ll be charged income tax on the money and a penalty for and early withdrawal.
If you plan to leave your current place of employment within the next five years, you shouldn’t borrow money from your 401(k).
Alternatives to borrowing from your 401(k)
Emergency fund
Emergency funds are generally about three- to six-months’ worth of pay that is set aside in case of sudden medical bills, home repair, a job loss, or any other unexpected financial change. If you don’t have access to reliable emergency funds, you may be more inclined to take out a loan on your 401(k) or personal loan in the event of a sudden bill or loss of a job.
Before contributing to retirement savings, you should set aside an emergency fund. Much like contributing to a 401(k), you don’t need to set aside huge chunks of your paycheck all at once if you’re budget isn’t that flexible.
“Having an emergency fund is important as it can help to reduce stress and prevent you from making bad financial decisions” says Zokai.
While an emergency fund doesn’t have the same earnings potential as a retirement savings account, setting aside a little bit of money here and there can make a big difference in the long run.
Personal loan
Instead of hurting your retirement savings, you can take out a personal loan. While you may have to pay a higher interest rate, the money in your 401(k) account will remain untouched and continue to grow with interest. But depending on your credit score and existing debt, you may be able to secure a lower interest rates compared to a 401(k) loan.
You won’t be restrained to the same 401(k) loan restrictions, which is helpful if you’re looking to borrow over $50,000. So if you need a larger sum of cash, a personal loan is likely a better option.
HELOC or home equity loan
Rather than taking a loan on your retirement savings, you can still borrow from yourself with a home equity loan or home equity line of credit (HELOC). HELOCs and home equity loans are generally more flexible compared with other loan options and may offer lower interest rates than a personal loan.
A HELOC allows you to make withdrawals for a certain period of time. After that, you’ll pay back the loan amount with interest through monthly installments for roughly 20 years.
A home equity loan is a loan that allows you to put up the equity on your house as collateral. These loans are usually fixed-rate loans and are often easier to get than some other loans.
Is it worth it to borrow from your 401(k)?
While a 401(k) loan may seem like an appealing option to pay off credit card debt or pay down your mortgage, you’ll probably end up paying more in taxes and losing potential market growth on those funds. While a 401(k) loan or 401(k) early withdrawal may help you out of a tight spot, your money will lose the advantage of compound interest as well as its tax advantages.
“I would suggest that participant explore and exhaust all options before taking a 401(k) loan,” Zokai says. “The opportunity costs that come with a 401(k) loan can be detrimental to the long-term success and retirement readiness of a participant.”
A good rule of thumb is, that if you can’t afford to live without it, don’t invest it. It’s better to not touch your retirement savings until you’re at least 59 1/2. If you find yourself low on funds, consider taking out a personal loan or taking out a second mortgage before touching your nest egg.
For personalized advice on your individual financial situation consider consulting a certified financial planner (CFP) or fiduciary financial advisor.
Our experts answer readers’ investing questions and write unbiased product reviews (here’s how we assess investing products). Paid non-client promotion: In some cases, we receive a commission from our partners. Our opinions are always our own.
With the rising cost of living making it more difficult to afford everything from groceries and gasoline to housing and health care, you might have thought about borrowing from your 401(k) to cover some of these expenses.
A recent T. Rowe price study found that 401(k) loans have been steadily increasing since 2020, although they still have not reached pre-pandemic levels. The firm noted that loans had decreased at the beginning of the pandemic as the government temporarily eased some restrictions on early withdrawals.
While a loan from your 401(k) can be a quick and secure way to get additional funding, prematurely withdrawing from your retirement savings plan could have severe consequences down the line.
Here are the pros and cons of taking out a 401(k) loan.
See Insider’s picks for the best retirement savings plans >>
How a 401(k) loan works
A 401(k) loan isn’t actually considered a true loan since you’re borrowing the money from your own 401(k). But that comes with significant consequences that may put a strain on your finances in the future.
“A 401(k) loan allows you to borrow money from your 401(k) and pay yourself back with interest,” says Matt Zokai director of retirement solutions at Avantax Wealth Management. “If your plan allows for loans, generally you can borrow the lesser of $50,000 or 50% of your vested account balance, which must be repaid in no more than five years.”
Anyone can take out a 401(k) loan at any time as long as your 401(k) plan allows loans and your plan administrator approves it. Unlike a personal loan, you won’t need approval from a bank nor will you need to get your credit checked.
401(k) loan: Pros and cons
| Pros | Cons |
|
|
Advantages of a 401(k) loan
Avoid taxes and penalties
A 401(k) loan is easier and less penalizing compared to a 401(k) hardship withdrawal. With a 401(k) hardship withdrawal, the amount you withdraw is taxed as regular income, plus you’ll be charged a 10% early withdrawal penalty fee.
Money from a 401(k) loan, on the other hand, is not taxed when you take it out, as long as you pay back the loan (and any accrued interest) on time. You also don’t have to claim your 401(k) loan on your tax returns. But keep in mind that the money used to pay off your loan will be after-tax dollars.
Pay interest back to yourself
Unlike a personal loan, you won’t be paying interest payments to a bank. Instead, the interest on your 401(k) loan is paid back to you, into your 401(k) account. Although you’ll be responsible for paying the interest on your loan at the time of payment, you aren’t technically losing that money.
Automated deductions
In the same way that 401(k) contributions can be automatically deducted from your paycheck, your loan payments can also be automatically detected from your take-home pay. Automatic payments are not only convenient but can also help prevent you from accruing interest or missing loan payments.
No credit check or impact on your credit score
Another convenient 401(k) loan beneift is that you won’t have to get a credit check in order to take one out. As long as your 401(k) plan permits loans and your plan administrator approves, there’s no other approvals needed. Also. 401(k) loans typically aren’t reported to the major credit bureaus, so your credit score won’t take a hit.
That also means that you won’t need to deal with the hassle of a loan application. But if you’re married, you may need your spouse’s approval before taking out a loan on your 401(k) loan.
A 401(k) loan may be the preferred option for folks with low to bad credit scores since they don’t have to worry about being turned down or further damaging their credit.
Disadvantages of a 401(k) loan
Funds won’t accrue compound interest
One of the biggest advantages of retirement savings plans like a 401(k) or IRA is the ability to accumulate compound interest over the long term. Even the smallest contributions here and there can significantly grow by the time you retire. So the sooner you start contributing to your retirement savings, the better.
“One of the biggest advantages of investing in a 401(k) is the power of compounding,” says Zokai. “The money you invest in stocks and bonds can earn dividends, interest, and also appreciate in value. Compounding means you are not only earning on the contributions you’ve made, but your earnings are also earning.”
Once the money exits your account, it will no longer accrue interest. Accruing interest on your retirement savings is essential to growing your wealth, but taking out a loan prevents that money from growing with the market. Even if you pay back your loan in a few years (with interest), you still won’t be able to make up for the lost time.
Estimate how much you need to retire with Insider’s retirement calculator >>
You may not be eligible to contribute to your 401(k)
You may not be able to continue contributing to your 401(k) while there’s an outstanding loan. Depending on your plan, you may have to wait years before being able to contribute to your retirement savings again. This means you’ll miss out on the tax advantages of contributing to your 401(k) plan during that time period, as well as possible employer match contributions. You’ll miss out on years of potential compound interest on your earnings.
“The most important part of saving in a retirement plan is starting to contribute,” Zokai says. “That may mean that you can only start with 1%, but you’ve at least begun the process and are potentially even taking advantage of an employer matching contribution.”
You’ll lose tax benefits
You’ll also lose your initial tax benefit as loan payments are made with after-tax dollars. Therefore canceling the advantage of the initial tax break you’d receive with a traditional 401(k) contribution. Plus, you’ll be taxed again when you start withdrawing funds when you reach retirement age.
Loan payments must also be made with after-tax dollars.
No bankruptcy protection
Personal loans are often dischargeable, which means you have protection in the event of bankruptcy. For example, if you have an existing personal loan from a bank or credit union and you go bankrupt, you may be eligible to have your personal loan forgiven.
But 401(k) loans are often not eligible for discharge in bankruptcy. That means if you go bankrupt and have an existing 401(k) loan balance, you’ll still be required to make payments. This may cause you more money and stress in the long run.
Can’t withdraw more than 50% of your vested balance
You can’t withdraw more than half of your vested 401(k) balance even if you’re looking to take out more. The maximum 401(k) loan is currently $50,000 or 50%, whichever is less. You also won’t be able to withdraw non-vested money.
Any money you deposit into your 401(k) plan is owned by you. However, employer-match contributions will technically not be yours until you’ve become vested.
Leaving your job may speed up the repayment schedule
If you leave your current place of employment or get fired, the payment schedule for your loan may be sped up. A 401(k) loan is generally paid back in about five years. But if you change jobs, you’ll might have to pay back your loan sooner. Unless your plan allows you to continue to make payments after your employment ends, you must repay your 401(k) loan balance by the due date for your federal tax return. If you fail to do so, you’ll be charged income tax on the money and a penalty for and early withdrawal.
If you plan to leave your current place of employment within the next five years, you shouldn’t borrow money from your 401(k).
Alternatives to borrowing from your 401(k)
Emergency fund
Emergency funds are generally about three- to six-months’ worth of pay that is set aside in case of sudden medical bills, home repair, a job loss, or any other unexpected financial change. If you don’t have access to reliable emergency funds, you may be more inclined to take out a loan on your 401(k) or personal loan in the event of a sudden bill or loss of a job.
Before contributing to retirement savings, you should set aside an emergency fund. Much like contributing to a 401(k), you don’t need to set aside huge chunks of your paycheck all at once if you’re budget isn’t that flexible.
“Having an emergency fund is important as it can help to reduce stress and prevent you from making bad financial decisions” says Zokai.
While an emergency fund doesn’t have the same earnings potential as a retirement savings account, setting aside a little bit of money here and there can make a big difference in the long run.
Personal loan
Instead of hurting your retirement savings, you can take out a personal loan. While you may have to pay a higher interest rate, the money in your 401(k) account will remain untouched and continue to grow with interest. But depending on your credit score and existing debt, you may be able to secure a lower interest rates compared to a 401(k) loan.
You won’t be restrained to the same 401(k) loan restrictions, which is helpful if you’re looking to borrow over $50,000. So if you need a larger sum of cash, a personal loan is likely a better option.
HELOC or home equity loan
Rather than taking a loan on your retirement savings, you can still borrow from yourself with a home equity loan or home equity line of credit (HELOC). HELOCs and home equity loans are generally more flexible compared with other loan options and may offer lower interest rates than a personal loan.
A HELOC allows you to make withdrawals for a certain period of time. After that, you’ll pay back the loan amount with interest through monthly installments for roughly 20 years.
A home equity loan is a loan that allows you to put up the equity on your house as collateral. These loans are usually fixed-rate loans and are often easier to get than some other loans.
Is it worth it to borrow from your 401(k)?
While a 401(k) loan may seem like an appealing option to pay off credit card debt or pay down your mortgage, you’ll probably end up paying more in taxes and losing potential market growth on those funds. While a 401(k) loan or 401(k) early withdrawal may help you out of a tight spot, your money will lose the advantage of compound interest as well as its tax advantages.
“I would suggest that participant explore and exhaust all options before taking a 401(k) loan,” Zokai says. “The opportunity costs that come with a 401(k) loan can be detrimental to the long-term success and retirement readiness of a participant.”
A good rule of thumb is, that if you can’t afford to live without it, don’t invest it. It’s better to not touch your retirement savings until you’re at least 59 1/2. If you find yourself low on funds, consider taking out a personal loan or taking out a second mortgage before touching your nest egg.
For personalized advice on your individual financial situation consider consulting a certified financial planner (CFP) or fiduciary financial advisor.
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