Are you thinking about using a 401(k) loan to manage your current financial situation? Your 401(k) plan is meant to help you find your retirement. Although you can withdraw money from it earlier than the qualifying distribution age, there can be positive and negative consequences to such an action. Although it typically goes against traditional finance philosophies to take money out of a retirement plan before you actually retire, there are some circumstances where this outcome might make sense.
A 401(k) plan is an employer-sponsored retirement account. Employee contributions go directly into the account through paycheck deduction. Then the organization offering this benefit will match a specific percentage or donate a certain amount to it as well so that it can grow. You would then invest the money into one of the funds offered through the workplace. Tax laws can vary each year, but you have been able to contribute $18,000 or more since 2017 into this plan.
You are discouraged from withdrawing money from this retirement option until the age of 59.5. There are tax penalties to consider if you do so, but there are some exceptions to that rule. You can start paying medical bills at the age of 55 if you are out of work or experience a disability. Then other method is to take out a 401(k) loan, and then repay the amount with interest.
These are the specific pros and cons of 401(k) loans to consider if you find yourself in a position where this financial resource is necessary.
List of the Pros of 401(k) Loans
1. You can use the money for a variety of reasons if there is enough for a loan.
People typically borrow funds from their 401(k) plan for a variety of reasons. You can use the money to create a new business opportunity, help to pay tuition costs for your children, purchase a vehicle, or even pay off other debts. If you manage your money well and know that your employment is secure, then this lending product can be an acceptable option since it can help you to borrow and repay quickly for certain investments.
Your success in this area depends on what the repayment clause is for your unique situation. As long as you follow all of the rules and put the money back into the plan, you can come out ahead on the other side.
2. You don’t need to go through a credit check to obtain a 401(k) loan.
One of the reasons why a 401(k) loan is a popular option in the United States is because there is no need for a credit check to occur. You are using the funds in this retirement plan as secure collateral for the money that you receive. If you are unable to pay back the payments, then it is treated as a distribution instead. Although there are tax consequences to consider if that outcome occurs, the lack of pressure to make a specific payment can help you out of a financially challenging issue.
3. You will receive a competitive interest rate with a 401(k) loan.
The interest rates on 401(k) loans are usually close to what the prime rate happens to be in the marketplace. That means this lending product is similar to what you would receive with the typical consumer loan. The primary difference is that you will pay back the loan principal and the interest to yourself instead of sending it to a bank or another financial institution. The entire amount of every loan that you take out and re-pay works with the balance of your overall 401(k) account.
Although financial experts suggest that using a 401(k) loan to pay off debt is a poor idea, you could pay off several high-interest credit cards or loans, save money over a long-term, and then pay yourself instead of other lenders the interest payments to help with your retirement.
4. The application fees for a 401(k) loan are minimal – if they even exist.
Because a 401(k) loan isn’t a “true” lending product in the traditional sense of the term, the application fees to access your cash are usually minimal. Some plans don’t even have an origination fee that you’ll need to worry about. If there is one, then this money will go to the plan administrator instead of your account, so it is an expense to think about if the fee is uncomfortably high.
Most plans charge an origination fee of up to $75. That means you could end up losing more than 7% of your value if you were to borrow $1,000 from your 401(k) to meet your current financial needs.
5. There are no early repayment penalties to manage.
If you take out some money with a 401(k) loan, then you can pay it back whenever there is cash available to do so. Unlike other lending products, you can pay back as much as you want with every paycheck. The only stipulation is that you need to be able to make the minimum payment based on the terms and conditions that you signed off on when applying for this option. When you add in the lower costs to access this liquidity asset, then there is no impact on your credit. Reducing the amount of long-term interest on a mortgage to avoid PMI can even help you to come out ahead in some situations.
6. It helps you to manage real-world situations with greater ease.
There are times in the real world when you must have money. Borrowing through the use of the 401(k) loan is a financially smarter choice then taking out a high-interest title loan, visiting a pawn shop, or using the so-called payday loan options that are available in some communities. Some terms are more reasonable than what you would receive with a personal loan. It is the fastest, easiest, and lowest-cost method to get the liquidity you need.
Taking out a 401(k) loan is only a taxable event unless you violate the repayment rules or the loan limits. There is no impact on your credit rating, and your FICO score will not change the interest rate you receive. Because of these unique advantages, most people see that it has little effect on the progress of their retirement savings. Your loan distribution is not taxed unless you meet other criteria.
7. Your 401(k) plan receives the interest from your loan payments.
It would be better to say that a 401(k) loan is more of an advance. Although you pay interest on the amount that you receive, anything that is charged goes into the account. You’re basically transferring money from one budget line to another. Even if you don’t experience a positive result from this outcome, the loss of progress is usually neutral or minimal if you manage your finances wisely.
8. Accessing your cash is fast and easy with a 401(k) loan.
Most 401(k) plans make it fast and easy to apply for a loan. There are no lengthy applications that you must fill out, and there is no need to wait on the results of a credit check. Most loans don’t even create an inquiry against your credit. You can request cash with just a few clicks on your administrative website, with a check in the mail in just a few days without needing to create a public record. Some plans are even issuing debit cards with the funds so that you can manage multiple loans at once or avoid taking cash.
You might even have the option to receive a direct deposit of your loan funds if you are receiving less than $10,000.
9. You get to specify the investment accounts from which you want to borrow money.
When you decide to take out a 401(k) loan, then you get to specify the various investment accounts from where you want to borrow the money. Then those are the assets which are liquidated for the duration of this lending products. The downside is that you would lose any positive earnings that would’ve been produced by those investments during the repayment. We must also consider the upside, which is the fact that you get to avoid any investment losses at the same time.
List of the Cons of 401(k) Loans
1. You will pay double taxation on the interest of the loan.
When you decide to take out a 401(k) loan, then you are going to be paying interest back into your plan using money that comes after taxation. You were originally contributing to the retirement option using pre-tax money. If you hadn’t borrowed the cash for the loan, then it would be earning tax-deferred interest inside of the plan. Because you are borrowing it out with the lending product, you must now earn the money, pay taxes on it, and then pay it back with interest.
When you withdraw the funds again later after you qualify for a distribution, you’ll be paying taxes on it again. That process effectively defeats the purpose of having a tax-deferred account in the first place.
2. You must repay the loan if you leave your employer or face potential tax consequences.
If you separate from your employer while you have a 401(k) loan that is active, then you are responsible for repaying any outstanding balance immediately – you have until the next tax filing deadline to manage this issue. The only exception to this event is if you have a separate agreement with the manager of this tax-advantage plan outside of your workplace rules, which is an uncommon occurrence. If you are unable to take care of the final balance, then the government treats the money as a taxable distribution.
Unless you are over the qualifying age to receive distributions, then you’ll find yourself paying the income tax on the amount of the loan that remains. You will then have a tax penalty to pay from that amount as well.
3. Your money is no longer protected from creditors.
When your money is in a 401(k) plan, then it is protected from bankruptcy and any creditors you might have. When you decide to borrow funds from it through a loan and remain in financial trouble afterward, a bankruptcy filing puts this money into reach for your bills. That is why you should never use this tax-advantaged plan to pay debt unless you have no other choice. It is better to keep it protected so that you can carry it with you into your retirement instead.
4. There are borrowing limits for you to consider with a 401(k) loan.
The Internal Revenue Service of the United States places a limit on the amount that you can borrow with a 401(k) loan. You can either choose the greater of $10,000 or 50% of your retirement balance, up to a limit of $50,000. That doesn’t mean your plan will actually accept these terms, so you will need to check with your administrator to see what is possible in your situation. Your company is permitted to offer less, and there is not an appeals process to follow if you need more.
5. You will need to start paying back the money with your next paycheck.
Most 401(k) loans do not offer a grace period when you receive the lump sum of money. It is not unusual to have the first payment come out of your next paycheck once you take out this lending product. Many of the employers will require you to use an automatic deduction to ensure that you make your payments on time. It is rare to have 30 days until your first payment. If your paycheck comes out tomorrow, then that might be when the initial payment gets made.
That is why you will want to review the schedule of your loan before deciding to take any money out of your 401(k) plan. If you cannot make that initial payment successfully, then it could create an immediate distribution and the tax consequences that apply in that situation.
6. You have a limited amount of time to repay the loan.
Unless you are using the money from a 401(k) loan to purchase a house, you are required to pay off the entire balance within five years or less. The length of the loan could be significantly longer if you use the funds to obtain a mortgage, but then this issue could present a unique financial challenge for your family if you leave your job for any reason. The outstanding amount would still become immediately due or qualify as a distribution.
If you are prepared to handle the tax ramifications of that situation, then this disadvantage may not apply. You will still want to evaluate all of the pros and cons in that situation to determine if it is the right way to finance your house.
7. There is a loss in investment growth that you must also consider.
When you borrow money from your 401(k) plan, then you have no way to invest it for your retirement. When it sits as an outstanding payment, then there is no way to help your money grow. Even if you invest it after taking the cash out, trying to beat the interest rate to come out ahead is almost impossible to accomplish. That means you are foregoing all potential investment gains from the funds that you borrow for the duration of the loan.
That also means you will be losing out on any gains that were possible through compound interest. Because you are essentially borrowing from your future self, this loss rarely gets you to the break-even point for your retirement.
8. You may be forbidden from future contributions until the loan is repaid.
Some 401(k) plans do not allow you to continue making contributions to your retirement until you repay the loan. You might be able to make after-tax contributions, but the advantages of pre-tax money goes away. This disadvantage can quickly derail your savings plan over time, which is why most financial advisors want you to look at other options before using money from your retirement to take care of your present needs.
Verdict on the Pros and Cons of 401(k) Loans
Pensions are becoming a financial resource of the past for retired workers. There are many workers in the United States where a 401(k) plan might be their only retirement option. The bar is set rather low to begin investing in this option, and your employer will do almost all of the work. Your job is simple: to opt-in to whatever plan is available. You don’t even need to know anything about investing to begin the savings process.
A 401(k) loan gives you the option to access the money that you have saved, including whatever employer match is in the account, when there is a financial need to manage. Although the money must go back into the plan if you want to avoid income tax issues and early withdrawal penalties, there are legitimate reasons why accessing these funds could work to restore your financial health.
The pros and cons of 401(k) loans are unique to every situation. If you need to borrow, then you might as well pay the interest to yourself instead of another bank. As long as your job is secure and you can afford the monthly payments, your future self won’t mind the short-term loan if it means that you can be in a better financial state.
Blog Post Author Credentials
Louise Gaille is the author of this post. She received her B.A. in Economics from the University of Washington. In addition to being a seasoned writer, Louise has almost a decade of experience in Banking and Finance. If you have any suggestions on how to make this post better, then go here to contact our team.