How 401(k) Loans Work – Pros, Cons, and Facts

If you’re considering taking out a loan on your 401(k), chances are you need some money for an emergency or unexpected financial obligation. When you put money into your 401(k), you knew that you were saving it for the long haul: retirement. Often times, “Life” happens and you find yourself in need of some money quick.

Taking out a 401(k) loan allows you to borrow up to $50,000 or 50% (whichever is less) of your 401(k) balance and repay it with interest within 5 years without penalty.

Before you decide to borrow from your 401(k) though, you should know all the facts about it and weigh the pros and cons.

How does a 401(k) Loan Work?

approved 401(k) loanA 401(k) allows you to borrow money that you’ve contributed to your employer sponsored retirement account with stipulations that you pay it back to the account within a set time frame (usually 5 years) and includes repaying not only the principal you borrowed but also the interest for the loan.

Not all retirement plans offer the ability to take out a loan. If you have a 401(k) policy that allows you to take out a loan, the maximum amount you may withdraw for a loan is either $50,000 or 50% of your 401(k) balance (whichever is less).

For example if you have a 401(k) that is worth $48,000, you may only withdraw $24,000 since that is 50% of your 401(k) balance. As another example if your balance is $120,000, 50% would be $60,000 but you would be capped out at $50,000.

Some plans allow for a one-time only loan on your 401(k) policy while others may allow multiple loans to be take out which overlap. The only issue with taking out multiple loans, is that you will still be bound by the cumulative total of $50,000 or 50% of the balance where the 50% is calculated based on the highest balance you had over the last 12-month period.

401(k) loans will have a time frame that the loan MUST be paid back in full. This is generally a maximum of 5 years with only a few exceptions. Some of these exceptions are that if you are taking a loan out to purchase a primary residence (home you will reside in and not a rental home) then you may be able to extend the duration of the loan. If you take a leave of absence for up to a year, you can stop making payments to your 401(k) but will need to resume upon returning to work and catch up on the payments as to not extend the original due date of the loan. If an employee is performing military service (ie. deployment or reserve duty), the loan may also be paused.

If you do not pay back the entire loan by the time the loan is due or miss payments, you will be placed in a default status. If you default on a 401(k) loan, your entire loan balance will be a “deemed distribution” and you will have the balance of your loan treated as income that year at the tax rate of whichever bracket you are in and in addition you will pay an “early withdrawal” tax of 10%. If your income bracket is 25%, you will be taxed 25+10=35% on the balance of that loan. Another word of caution is that if this distribution now bumps you into a higher tax bracket, you will pay the higher bracket rate. Defaulting on a 401(k) loan definitely comes with some monetary consequences!

If you happen to lose your job, your employer can and probably will require you to pay off the balance in full immediately. In the past immediately meant within 60 days but the Tax Reform of 2018 extends this to the date that your tax return is due. This can create another financial burden on you though.

Some plans have a clause that allows you to offset your 401(k) balance for the unpaid portion in the even that you lose you job and you can rollover the offset balance to a new employer 401(k) but it must be done by your tax return due date as well.

For additional questions and answers you may have, check out the IRS FAQ for Retirement Plans.

Pros of a 401(k) Loan

pros and cons of 401(k)Before I go over the pros, I must stress that you read on to the cons as well. I believe you will do yourself a real disservice if you do not know the risks associated with this type of loan as well!

  • Qualifying for a 401(k) loan is generally easy since you are borrowing against yourself. If your plan allows you to access your 401(k) through a loan, the process is usually pretty simple.
  • There is no credit check for a 401(k) loan since you are borrowing money from yourself.
  • The interest you pay on the 401(k) goes into your 401(k). You aren’t paying interest to a bank or lender, you’re paying it back to you

Cons of a 401(k) Loan

  • You will lose out on the compound interest of amount that you borrow since it is no longer invested for you.
  • If you default on the loan you are taxed on the entire balance of the loan at the rate of your income tax bracket with an additional 10% early distribution penalty tax. This can be quite hefty depending on the amount you borrow.
  • If you are put in a position that you need to take out a 401(k) loan, you are more likely to find yourself in that position again unless you really dig deep to determine why you needed this loan and change your habits or situation to avoid this need in the future.
  • If you leave your job while you are in the middle of paying back a loan from your 401(k), your employer can (and is likely) to require you to pay off the balance in full immediately (by due date of your tax return.)

Key Takeaways

If you are thinking about taking out a 401(k) loan, look over all the pros and cons and determine if this is the right decision to you. Ask yourself the following three questions at a minimum:

  1. How secure is my job?
  2. How certain am I that I will be able to pay off this loan on time?
  3. Is this a one time necessity or an additional burden that I’m stacking on myself?

Sometimes, taking out a 401(k) loan is the smartest thing for your financial situation. If so, just contact your plan coordinator to walk you through the steps.

For more helpful information, read my article on how to save for an Emergency Fund for future times that you many need money to help you avoid needing to dip into your retirement account again.

What did you learn from this article after reading it? Let me know in the comments below. If you have any questions that I didn’t cover, I’ll try to answer those below as well. If you know someone that could benefit from this post on how a 401(k) loan works, please share it with them as well!

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