Money Girl's Quick and Dirty Tips for a Richer Life

Taking 401(k) Loans–11 Pros and Cons You Should Know

Episode Summary

Whether you should take a loan from your workplace retirement plan depends on your financial circumstances and plan for using the funds.

Episode Notes

Laura answers a listener’s question about 401(k) loans and using them to pay off credit card debt. She covers 11 pros and cons of taking a loan from a workplace retirement plan, such as a 401(k) or 403(b).

Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.

Have a money question? Send an email to money@quickanddirtytips.com or leave a voicemail at 302-365-0308.

Find Money Girl on Facebook and Twitter, or subscribe to the newsletter for more personal finance tips.

Money Girl is a part of Quick and Dirty Tips.

Links:
https://www.quickanddirtytips.com/
https://www.quickanddirtytips.com/money-girl-newsletter
https://www.facebook.com/MoneyGirlQDT
https://twitter.com/LauraAdams
https://lauradadams.com

Episode Transcription

Hello, friends, and thanks for joining me on another weekly Money Girl episode!

My name is Laura Adams–I'm an award-winning personal finance author and creator of online money classes.

My debt course is a best-seller called Get Out of Debt Fast–A Proven Plan for Debt-Free Personal Finances. If you’re ready to build your credit scores, don’t miss my credit course called Build Better Credit–The Ultimate Credit Score Repair Guide. Find them on my website at LauraDAdams.com!

Since 2008, I've been bringing you personal finance and small business tips that boost your financial wisdom, wellness, and security. I cover a range of topics and also interview subject matter experts and interesting folks from time to time.

I'd love to hear if you're enjoying the show or if it's helped you improve some aspect of your financial life. You can do that by leaving a review, calling 302-364-0308, or visiting LauraDAdams.com. My site has an email contact page and info about my work, books, and debt and credit courses.

Today’s topic is courtesy of Neelema, who says, “Hello Laura, I enjoy the Money Girl podcast. I’m an anesthesiologist married to a hospitalist. We wanted to buy real estate and I took a loan from my 401(k) for $40,000 at 4.5% interest. However, we never bought a property. We have $45,000 in credit card debt with a 25% APR, costing $800 per month in interest charges. Should we use the loan to pay off the credit card?”

Thank you for the question, Neelema! This show will answer your question and review 11 pros and cons of taking a loan from a workplace retirement plan, such as a 401(k) or 403(b).

What is a 401(k) retirement plan?

If you’re a regular Money Girl listener or are fortunate enough to have a retirement plan at work, you probably know that a 401(k) is a popular and powerful savings vehicle. Once enrolled, you elect a percentage or flat dollar amount of each paycheck you want to contribute to your traditional or Roth plan.

For 2023, you can contribute up to $22,500 or $30,000 if you’re over 50 to most workplace retirement plans. Additionally, many employers encourage saving by “matching” your contributions, allowing you to exceed those annual limits. You choose how to allocate your retirement funds using an investment menu that typically includes index, exchange-traded, and money market funds.

ALSO READ: Your Complete Guide to 401(k) Retirement Accounts

What is a 401(k) loan?

Now, let’s talk about 401(k) loans and how they work. A 401(k) loan isn’t technically a loan because there isn’t a lender. It’s just your ability to tap a portion of your account tax-free if you repay it with interest and on time.

While it might seem strange to repay yourself for a 401(k) loan with interest, the purpose is to compensate for lost time. When you withdraw money from a retirement account for any reason, the funds aren’t invested and can’t grow.

The first hurdle to taking a 401(k) loan is that it must be allowed by your retirement plan. Ask your benefits administrator or check the rules by reviewing the summary plan description (SPD) document, which you should receive every year. Due to the paperwork and time that’s required to administer retirement loans, small companies may not offer them.

If you can take a 401(k) loan, the limit is half your vested balance, up to $50,000. For example, if you have $60,000, the maximum you can borrow is $30,000 ($60,000 x 0.5).

And if your 401(k) balance is $200,000, the most you can borrow is $50,000. You can even take multiple loans if the total doesn’t exceed $50,000.

Retirement account loans have an interest rate and term in the plan document. The repayment period is typically five years, but it may be longer if you use borrowed funds to buy a home. You must make payments in equal amounts that include principal and interest, which get deducted from your paychecks.

If you repay a 401(k) loan on time, you won’t owe income taxes or penalties. However, if you don’t repay it on time, the outstanding balance gets considered an early withdrawal if you’re younger than 59.5. In that case, you’d be subject to income tax plus an additional 10% penalty on the entire unpaid loan amount.

Additionally, if you leave your job, get laid off, or are fired, your outstanding loan balance becomes an early withdrawal unless you repay it by your tax filing deadline. Again, if you can’t repay the entire outstanding balance on time, you’ll have to pay income tax plus the 10% penalty if you’re younger than 59.5.

LISTEN ALSO: 7 Pros and Cons of Investing in a 401(k) Retirement Plan at Work

What is a 401(k) hardship withdrawal?

If your retirement plan at work doesn’t allow loans, or you need more than the allowable loan amount, you may be eligible for a “hardship” withdrawal if permitted by your plan. Hardships are specific circumstances approved by the IRS, including paying for college, buying a main home, avoiding foreclosure on a primary residence, or having unpaid medical or funeral expenses. They are the only option for taking withdrawals from a workplace retirement plan prior to age 59.5 or early retirement at age 55.

The downside of a 401(k) hardship withdrawal is that they’re not tax-free. You must pay income taxes plus a 10% early withdrawal penalty if you’re younger than 59.5. Plus, you can't contribute to your retirement account for six months after taking a hardship withdrawal.

ALSO LISTEN: 7 Changes to Retirement Accounts in 2023 You Should Know

5 pros of taking a 401(k) retirement account loan

Let’s review five benefits you get from a retirement account loan.

1. You receive funds quickly.

Since there isn’t an actual 401(k) lender, you don’t have to complete an application, verify your income, or submit years of income tax returns. However, you must sign a loan document with the institution that administers your plan to agree to the interest rate, repayment terms, amount to withdraw, and account to deposit your funds.

Your 401(k) loan funds are usually available within a week. So, when you need quick access to money and know you can repay it on time, a retirement plan loan can be a good option.

2. You pay a low interest rate.

As I mentioned, the interest you pay goes into your retirement account to help make up for the lost time in the markets. It’s typically lower than what you’d pay for other debt, such as credit cards and personal loans. Neelema said she’s paying 4.5% for her $40,000 401(k) loan, which is lower than the going rate for 30-year mortgages.

3. You don’t need good credit. 

Since no lender must approve you for a 401(k) loan, your credit isn’t a factor. If your retirement account allows loans, you can get one no matter what’s going on with your finances or even if you have poor credit.

4. You can spend it as you like.

When you take a 401(k) loan, how you spend it is entirely up to you. However, as I previously mentioned, using a loan to purchase a home may qualify you for a longer repayment term. So, let your benefits administrator or retirement account custodian know if you plan to use any portion of a retirement loan to buy, build, or remodel a home.

5. You have a short repayment term.

Unless you use a 401(k) loan for a home, you typically must repay it in five years. Having a relatively short repayment term can help keep your financial life on track with less debt and more money invested for retirement.

And depending on what happens in the financial markets, repaying a 401(k) loan with interest could even leave you with more in the account than if you didn’t take a loan.

6 cons of taking a 401(k) retirement account loan

Here are six downsides of a 401(k) loan to consider.

1. You can’t borrow more than the limit.

As I mentioned, if your retirement plan allows loans, the maximum is $50,000 or 50% of your vested account balance, whichever is less. And there may be a minimum loan amount, such as $1,000.

Your vested balance is the amount in the plan that you own. Note that you’re always 100% vested in your retirement contributions. However, your employer’s contributions, such as matching contributions or profit-sharing, are typically subject to a vesting schedule.

So, check your plan document or ask your benefits administrator for details if you're unsure how much your 401(k) balance is vested. You'll have to look for other lending options if you need to borrow more than the limit.

2. Your payments get deducted from your paychecks.

In general, you can’t make a lump-sum repayment for a 401(k) loan because payments get automatically deducted from your paychecks. However, some plans allow you to make monthly or quarterly loan payments.

So, be sure you know your loan payment and that you can afford it. Missing a payment means your entire outstanding balance could be considered an early withdrawal, subject to taxes and a hefty penalty.

3. Your interest is not tax-deductible.

As I mentioned, money borrowed from your 401(k) is tax and penalty-free if you follow all the rules, but not interest-free. Another critical point is that unlike interest paid on a mortgage or student loan, which may be partially tax-deductible, interest paid on a retirement plan loan is never tax-deductible.

In other words, if you plan to use a 401(k) loan to buy a home or pay for education, you’d be better off getting a mortgage or student loan. Those products allow you to deduct all or a portion of your interest from your taxable income, reducing your tax liability.

4. You miss potential investment gains.

The purpose of having a retirement account is to grow money for the future. Funds you withdraw for a loan miss out on potential investment growth. Even if you repay a 401(k) loan on time, you could end up with less than if you hadn't taken a loan.

Since no one knows what will happen in the markets, you can't say how much growth you'd miss by taking a retirement account loan.

5. You could have an expensive penalty.

If you take a 401(k) loan and something unforeseen happens, such as losing your job or other hardship, you could end up in a tight spot. Separating from your employer for any reason means your entire loan balance is due by your tax filing deadline and is subject to taxes plus a penalty if you’re younger than 59.5.

So, ensure all is well with your job before you take a retirement account loan.

6. You have less protection from creditors.

Another 401(k) loan consideration is that workplace retirement plans have protection from a federal law called the Employee Retirement Income Security Act of 1974 (ERISA). One of the key safeguards is giving you protection from creditors if you have a financial catastrophe.

There are exceptions when a qualified-ERISA plan is at risk, such as when you owe the IRS for federal tax debts, owe criminal penalties, or owe an ex-spouse under a Qualified Domestic Relations Order. But having money in a retirement plan at work gives you unique financial protections.

Should you take a 401(k) loan?

Whether you should take a loan from your workplace retirement plan depends on your financial circumstances and plan for using the funds. If you're younger than 59.5 and have a secure job, taking a 401(k) loan at 4.5% or 5% interest may be better than getting a 401(k) hardship withdrawal or a high-rate loan.

If your retirement plan offers a free consultation with an advisor, take advantage of the opportunity to get customized advice and understand your options. Thinking carefully about the pros and cons of a 401(k) loan before tapping your retirement account is critical.

Now, let's return to Neelema's question about what to do with her unused 401(k) loan proceeds of $40,000. She has $45,000 in credit card debt at a sky-high interest rate of 25% APR, costing her $800 a month in interest, and she wants to know if she should pay it off with the 401(k) loan.

Neelema, I'm concerned that you've accumulated so much credit card debt without a plan for paying it off. It sounds like you and your spouse have good jobs in the medical industry. With two steady incomes, you should be able to budget a portion of your monthly incomes to pay it down over time.

Also, I’d like you to consider using a better credit card that charges less than 25%. Even if your credit isn't perfect, you should be able to get a card charging half that rate. However, the best way to use a card is paying off your balance in full each month so you get all the benefits without paying a penny of interest.

Eliminating most of your credit card balance with your low-rate 401(k) loan would substantially cut your interest expense–so I think it’s a good idea for your situation. Plus, you'll have a structured five-year repayment period for the loan. But you could also repay the loan to your 401(k) ahead of schedule with no prepayment penalty, if you like.

If there's any reason you think your employment may not be stable, repaying the loan could be wise. Remember that you'd have to repay the entire $40,000 by your tax filing deadline to avoid taxes and an additional 10% penalty, assuming you're under 59.5. So, factor in that potential risk.

Also, anytime you use new debt to pay off credit cards, you must commit to never racking up your cards again. Otherwise, you’ll end up going deeper into debt and the 401(k) loan won't improve your finances in the long run. Neelema, thanks again for your question and I hope this points you in the right direction!

That's all for now. I'll talk to you next week. Until then, here's to living a richer life.