Taking out a 401(k) loan comes with a lot of benefits including tax benefits and the possibility for 401(k) loans. A 401(k) loan allows you to borrow against your retirement savings and pay the money plus the interest back to yourself. While this method of borrowing sounds great, there are pros and cons of borrowing from 401(k) you should know before submitting your loan application.
Due to the potential of losing money or defaulting on your 401(k) loan, taking a loan from your 401k should be carefully considered because of tax implications and the impact on your future retirement savings.
Here are the pros and cons of borrowing from a 401(k) loan you need to know.
Pros of borrowing from 401(k)
Having a 401(k) plan comes with many benefits which can help you boost your retirement savings.
Here are the pros of borrowing from 401(k) you should know.
1. Immediate access to funds
A 401(k) loan provides you with instant access to your own money. The application process is simple and faster than private loans. This means your waiting time is much shorter than traditional loan approval processes which gives easy access to cash, especially during emergencies. No credit check is needed or no down payment, etc. All you need is a loan application and more likely consent from your spouse.
2. No credit check
401(k) loans generally do not require a credit check. This makes these loans an attractive option if you are facing higher interest rates due to having bad credit or when you can’t qualify for a private loan at all.
3. Lower interest rates
The interest rates on 401(k) loans are typically lower than other forms of debt, such as credit cards or personal loans. This could save you significant money over the life of the loan. Typically, the interest rate on your 401(k) loan is % to 2% over the prime rate. For example, if the prime rate is 3%, your 401(k) loan will be about 4% to 5%.
4. 401(k) loan payments are made to yourself
When you take a 401(k) loan, you essentially borrow from yourself. The repayments, including the interest, go back to your account, not to a bank or a lender. This allows you to grow your retirement savings much faster.
5. 401(k) loans are flexible
401(k) loans often have more flexibility regarding their usage and there are fewer limitations to what you can do with them. Whether it’s for home repairs, medical bills, education costs, or even a down payment for a home, a 401(k) loan can provide you with the funds you need when you need them.
6. A 401(k) allows you to avoid potential penalty and taxes
Most people make a big mistake with their 401(k) by taking withdrawals before they reach 59 ½ which comes with unintended consequences.
If you’re under 59 ½ years old and withdraw money from your 401(k), you will face a 10% early withdrawal penalty and income tax. With a 401(k) loan, you can avoid these extra costs.
Cons of 401(k) loans
While there are a lot of 401(k) benefits that sound promising, the loan also comes with potential drawbacks you should keep in mind. The following are the cons of a 401(k) loan you need to know.
1. Debt accumulation
Borrowing from your 401(k) might seem like an easy solution, but it promotes a cycle of debt. Once you start dipping into your retirement savings, it’s tough to break the habit, leading to an accumulation of debt. And if you can’t pay back your loan, you risk paying a 10% penalty on the defaulted 401(k) loan if you are under 59 ½ plus income tax.
2. High fees and penalties
If you fail to repay your 401(k) loan on time, heavy penalties and income tax kick in. Not only can these be very costly, but they can also lead to a severe depletion of your retirement savings.
Related post: What happens when you default on a 401(k) loan?
3. Double taxation
One of the biggest drawbacks of 401(k) loans is double taxation. Yes, the funds you have borrowed will be taxed twice. First, they will be taxed when you pay back the loan from your after-tax earnings, and second, when you withdraw them during retirement.
4. You lose earnings and interrupt the compounding effect
When you take a loan from your 401(k), you lose out on potential gains that money could have earned if it had remained invested. The longer your repayment period, the more potential growth you miss out on. While you will have only 5 years to pay off your 401(k) loan, 5 years are enough to slow down your account growth.
5. Immediate loan repayment upon termination of your job
Having a 401(k) loan is risky especially if you are planning to leave your job. If you lose your job or switch employers, you typically have to repay the entire outstanding balance of your loan within 60 days. If you fail to do so, it will be treated as a withdrawal and subjected to taxes and penalties.
6. 401(k) loan leads to having a false sense of security
Having access to a 401(k) loan can create an illusion of financial security, leading to poor financial choices or a lack of proper saving and budgeting. The illusion of financial security could also lead you to tap into your 401(k) loan unnecessarily, leading to long-term financial hardships.
7. Reduced take-home pay
Repayments for a 401(k) loan are done with after-tax dollars which decreases your take-home pay. Having a 401(k) loan to pay off means you need to realize more of your income which could put you in a higher tax bracket. This can lead to paying higher taxes which can potentially lower your take home and put a strain on your monthly budget.
Who gets the interest on a 401(k) loan?
The person who borrows from a 401(k) gets the interest on the loan. When you take out a 401(k) loan, the interest you pay goes back into your own 401(k) account. Essentially, you are paying interest to yourself as a form of added savings for your future retirement.
Will my employer know if I take a 401(k) loan?
When you take out a 401(k) loan, your employer will more likely know. At the end of the day, your HR might be notified as they are the ones who will adjust your paycheck and make sure your monthly payments are taken off through payroll deduction.
Can I borrow from my 401k if I no longer work for the company?
Typically, most plans allow 401(k) loans only when you are still employed by the company that sponsors the plan. But once you leave your job, you generally can no longer take out a new loan. If you have an existing loan, some plans may require you to pay it back in full upon termination or within 60 days. If you can’t repay it, it’s considered a default on the loan. Such default is considered a distribution and is taxable, with potential early withdrawal penalties if you’re under the age of 59.5 years.
How much can I borrow from my 401(k) loan?
The rules of your specific 401k plan determine whether or not you can take a loan. Most plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. For example, if your vested balance is $130,000, you can only borrow $50,000 since 50% of your vested balance is higher than the maximum the IRS allowed. On the other hand, if your vested balance is $45,000, the maximum you can borrow from your 401(k) is $22,500.
More retirement tips
Can you lose your 401(k) plan?
