If you’re short on cash or having a big bill coming due, it may be tempting to dig into your nest egg with a 401(k) loan. However, there are serious implications to understand before borrowing from your 401(k). 401(k) loans allow you to borrow temporarily from your retirement funds, but there are many strings attached.
If you don’t follow the rules carefully, you could wind up paying taxes and penalties. To make matters worse, you’re taking away savings that you may need for retirement. Keep reading to learn more about how 401(k) loans work and why borrowing from 401(k) accounts may not be a good idea.
When you contribute to a 401(k), you’re building a strong foundation for your retirement. Those funds are committed to your 401(k) until you reach the government-mandated minimum age for 401(k) account withdrawals — that’s 59 ½ years old according to current IRS rules. Withdrawals once you reach that age are generally taxable but don’t incur any additional penalties or fees.
If you want to withdraw earlier than age 59 ½, you’ll pay penalties on top of the standard taxes. The early withdrawal penalty is a whopping 10% on top of whatever income tax you already pay. Between the two, you could easily see 35% of your withdrawal taken by Uncle Sam. If you’re in a dire financial situation and the only resource you have is your 401(k), you can avoid those taxes and fees with a 401(k) loan.
401(k) loans allow you to tap into your retirement balance before turning 59 ½ without taxes and penalties as long as you repay the funds within five years in most cases. If you don’t pay back in time, you’ll be on the hook for taxes and penalties. However, if you can repay on time, you will essentially be repaying yourself.
Every 401(k) plan has different rules, and not all allow 401(k) loans. The easiest way to find out if you are eligible for a 401(k) loan is to check your plan documents or website. If you need additional help, you can contact your 401(k) plan administrator directly.
In most cases, you’ll “apply” for the 401(k) loan through your plan administrator. Because you’re really borrowing from yourself, the application process is usually quite simple. However, there is some administrative work to set up the loan, sell investments, withdraw the funds, and prepare a loan repayment plan. For all of the important details, check with your 401(k) provider.
In addition to any rules set by your employer, there are IRS limits around how much you can borrow from your 401(k). These are the most important details to know about:
Based on these rules, most people will be able to borrow between $10,000 to $50,000 with a 401(k) loan, depending on your 401(k) account balance.
After you receive your loan, you’ll typically be required to make payments back to your 401(k) account on at least a quarterly basis. You have to pay the entire balance back within five years unless you use the proceeds to buy a primary residence.
You’ll also have to pay 401(k) loan interest, which may be listed in your plan documents. Rates are typically around the Prime Rate plus 1% to 2%. The Prime Rate is a rate reserved for the highest-credit borrowers and can be tracked in places like the Wall Street Journal. The interest is good motivation to pay back your loan early. As an added perk, you get to keep the interest for retirement.
If the balance isn’t repaid within the time limit, the balance is reported as a distribution to the IRS and may be subject to taxes and penalties. These are generally made up of:
If your income tax rate is 25% and you also have to pay a 10% penalty, that’s a total of 35% of what you borrowed. To state the obvious, that’s a big hit to your retirement savings.
If you leave your employer before repaying your loan, the entire balance becomes due right away. It doesn’t matter if you leave voluntarily, if you’re fired, or laid off. Any outstanding balance has to be repaid right away. For employees who are let go unexpectedly, this can create a major hardship. This is a critical rule for you to know before taking a 401(k) loan – if you won’t have the funds ready to repay, you will be subject to those taxes and penalties we discussed earlier.
If you work directly with your 401(k) provider, there’s a good chance your employer will never know you took out a 401(k) loan. This is even more likely with larger employers where managers have no involvement in payroll outside of setting salaries and approving time cards.
However, it’s always possible that your employer may find out. Because 401(k) loan repayment is often handled as a payroll deduction, your employer may see that deduction. There’s no way to shield this information from your employer with 100% certainty, so you may want to skip a 401(k) loan if you’d rather keep your loan private.
If you change employers while you have a 401(k) loan outstanding, you can still roll over your 401(k) when you change jobs. However, that requires you to repay your loan completely before rolling over your balance. Remember, your entire outstanding loan balance is due immediately if you leave your job for any reason.
Rolling over your 401(k) is an important part of managing your finances when you leave a job. In most cases, leaving funds with an old employer’s 401(k) plan subjects you to fees while limiting your investment options. You’ll likely want to roll over a 401(k) account to a new employer or to your own IRA or Roth IRA, so make sure you consider this before taking a 401(k) loan.
In most cases, taking a 401(k) loan is not a good idea. Unless a 401(k) loan is absolutely necessary, you may be better off looking elsewhere for financial resources. In addition to risking your retirement savings, you could wind up paying taxes and penalties that could easily be worth more than a third of your loan if you can’t repay on time and in full.
Generally, it’s best to leave those retirement funds alone until you’re ready to retire. This will keep your funds invested and avoid taxes and penalties, which is the best way to maximize your retirement savings during your working years. Once you’re ready to retire, you can start to withdraw and get to work improving your fishing skills, or whatever it is you want to do when you retire.