Your 401(k) is an employer-sponsored retirement account that you fund with deductions from your paycheck and with matching contributions from your employer if applicable. The purpose of a 401(k) is to build a nest egg for your retirement, but what if you need money sooner?
Borrowing from your 401(k) can seem like a good option because it is more affordable and accessible than other products. However, a 401(k) loan will have a significant impact on your savings and income during retirement.
Here are a few things to consider before you borrow money against your nest egg.
What is a 401(k) loan?
Technically speaking, a 401(k) loan is not considered as a loan. It's a way to access your 401(k) balance early without any penalties as long as the balance is replaced within a specific timeframe. The advantage of borrowing against your 401(k) is that you can access money without going through a credit check.
Most plan providers offer interest rates that are lower compared to other loan products. If your 401(k) balance is under $20,000, you can borrow up to $10,000. However, you can't borrow more than $50,000 or 50 percent of your total balance depending on which amount is lower.
Your plan provider might have additional limits in place regarding how much you can borrow, such as a minimum loan amount.
How to apply for a 401(k) loan
You should reach out to the department that handles your benefits at work or contact your 401(k) plan provider. You will need to fill out some paperwork and might need to submit documents showing how you will use the funds. Your plan provider might also need documents proving that you meet their requirements to qualify for a 401(k) loan.
Your plan provider will go over the requirements, terms and interest rate of the loan with you. Find out what the payments will be and make sure the amount of the loan and payments are a good match for your needs.
Paying the loan back
A 401(k) loan is typically paid back over the course of the next five years via payroll deductions. Some plan providers offer longer terms such as 10 or 15 years if you use the loan to finance the purchase of a home.
The IRS requires that you make at least quarterly payments to replace the 401(k) balance you borrowed against, but your plan provider might have different rules. Monthly or bi-weekly payroll deductions are the most common way to repay a 401(k) loan.
Paying the loan back can become an issue if you quit or lose your job. You would have 60 days to finish paying off the outstanding balance on your loan. If you are unable to pay the remaining balance within 60 days, your loan will be considered as an early distribution and subject to the 10 percent penalty tax.
This tax will apply to the balance that is left unpaid at the end of the 60 days period and not to the total amount of the loan. You could end up with a large tax bill if you were to quit or lose your job before repaying a 401(k) loan in its entirety.
What is the impact on your savings?
Withdrawing money from your 401(k) will have negative consequences on your nest egg, even if you replace the money within the term set by your plan provider. The money will be replaced by deductions from your paychecks.
This means you will probably have to stop making contributions to your 401(k) until the loan is paid off. You will miss out on your employer matching your contributions if applicable. Contributions to a 401(k) are made with pre-tax money. However, you will repay the loan with your after-tax dollars.
This means you will pay taxes twice, once before you repay the balance of the loan, and a second time when you take distributions from your 401(k) during retirement. You should also keep in mind that the money you withdraw from your 401(k) won't be able to grow.
This will result in a lower 401(k) balance. The younger you are, the more of an impact a 401(k) loan will have on your balance. Each dollar you contribute to your 401(k) now will have decades to generate interests and make your nest egg grow. Depending on whe you pay back the loan, applying for a 401(k) loan means the money you withdraw won't generate any interests for a few years and you won't be able to invest the interests that this money would have generated.
Penalties and exceptions
There are no penalties associated with a 401(k) loan as long as you repay the loan in time other than missing out on an opportunity to have this money grow. If you fall behind on your payments or lose your job, you could end up paying a 10 percent penalty tax on the remaining balance of your loan. Some plan providers offer a grace period to help you get caught up on payments.
However, you will be exempt from making payments for a while if you are on family or medical leave and no longer receive a paycheck. If you become disabled before repaying the 401(k) loan, you would qualify for a penalty-free distribution and would no longer have to repay the remaining balance on your loan.
Other alternatives to explore
There are other options to explore if you need money. You can qualify for a hardship withdrawal from your 401(k) if you need to cover medical expenses or want to avoid foreclosure on your home. You won't have to pay the money back, but a hardship withdrawal will significantly reduce the size of your nest egg.
If you have an IRA, you should know that you can withdraw money without penalties. You won't have to repay the money. However, early withdrawal from your IRA would also reduce the income that is available to you once you retire.
You should consider other loan products such as a mortgage if you need money to purchase a home, or a home equity loan if you need to finance home repairs. Even a personal loan or credit card can be more advantageous than a 401(k) loan if you need to borrow a small amount.
Compare different options to find a product that matches your needs and budgets. Interest rates will be higher compared to a 401(k) loan, so to really determine if the 401(k) is the your best option, you need to understand the near term and long term implications of both the interest rates as well as the opportunity costs of taking money from your 401(k).
If you are looking at a 401(k) loan to get out of debt, you should consider credit counseling instead. Setting up a repayment plan adapted to your budget will help you get out of debt without using funds from your 401(k).
Borrowing against your 401(k) can be tempting due to low interest rates, but other options usually make more sense once you take into consideration the fact that a 401(k) loan will significantly impact the growth of your nest egg.
If you use GuidedChoice advisory service, you can model what taking a loan from your 401(k) might mean for your future so you at least have that piece of information when trying to determine the best path for you.