[Updated article; original publish date 3/18/20]
How 401(k) loans work
Here are the general rules that apply if your plan allows loans. We say if because not all plans offer this feature.
- Loan limits—The most you can borrow is generally the lesser of 50% of your vested account balance or $50,000. However, your plan may have a lower limit.
- Repayment period—You have to repay the loan within five years, unless it’s for the purchase of your primary home. And the payments must be made at least quarterly.
- Interest rate—You’ll have to pay interest on your loan, just like you would if you borrowed money from a bank. The difference is that the interest goes into your 401(k) account. Your plan sets the interest rate for your loan, and it’s typically tied to the prime rate.
- Fees—Your plan may charge you loan application and processing fees. These fees are taken from your account, not the amount you’re borrowing.
- Taxes—You’ll have to pay taxes on the loan if it isn’t repaid, and a 10% early withdrawal penalty if you’re under age 59½.
Pros and cons of 401(k) loans
Why would someone consider borrowing from their retirement account when they need money? There are a few reasons:
1 Preapproval isn’t required (although you may have to complete paperwork)
2 The interest rate is generally lower than what a bank may charge
3 You pay yourself back; the principal and interest go into your retirement account
However, these benefits come with a significant downside, besides fees and possible taxes. When you take money out of your account, you miss out on the growth it might have earned. As a result, it may take you a lot longer to reach your savings goal. And it can be tough to catch up even if you keep contributing while you repay your loan.
Here’s an example of the potential impact a loan can have.
This is a hypothetical mathematical illustration only. It represents no particular investment and does not account for taxes. Figures are based on assumptions as set out, and individual circumstances may vary. Assumes a loan of $10,000, an annual salary of $30,000, a beginning balance of $20,000, 30 years until retirement, a 7% annual rate of return compounded monthly, and a loan interest rate of 4.25%. There is no guarantee that any investment objective will be met.
Alternatives to borrowing from your 401(k) account
For this reason, a 401(k) loan should generally be your last resort, after you’ve considered all your other options, such as:
- Cutting other expenses in your budget to help cover your immediate financial need
- Tapping into your emergency savings fund
- Withdrawing money from your non-retirement savings and investment accounts
- Borrowing from a bank or another financial institution
- Asking family members for support
Using one or more of these options may eliminate your need to take a 401(k) loan or reduce how much you have to borrow, helping you keep your retirement savings on track.
Borrowing responsibly
If, after thoughtful consideration, you decide a 401(k) loan is still your best option, consider these tips to help lessen the impact.
- Don’t take more than you need
- Keep contributing to your account
- Repay the loan in full as soon as you can
401(k) loans—a lifeline for emergencies, not everyday
A 401(k) loan can be a lifesaver when life throws you a curveball and your resources are limited. But it’s important not to treat your retirement account like a savings account. Remember, you’re setting aside this money for something bigger—your future.
