Laura reviews the rules, pros, and cons of borrowing from a workplace retirement plan, such as a 401(k) or 403(b).
Laura reviews the rules, pros, and cons of borrowing 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.
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If you have access to a retirement plan at work, like a 401(k) or 403(b), it's a terrific way to invest for the future and get money-saving tax advantages. Once enrolled, you elect a percentage or flat dollar amount of each paycheck you want to contribute to your account. Some plans allow participants to take loans up to certain limits.
This post will review the rules and pros and cons of borrowing from your 401(k). You'll learn some downsides to avoid and tips for making wise decisions about your retirement funds.
Welcome back to episode 920 of Money Girl! I'm Laura Adams, an award-winning author, on-camera spokesperson, female money speaker, founder of The Money Stack, a Substack newsletter, and host of this podcast with over 43 million downloads.
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What is a 401(k) loan?
A 401(k) or 403(b) loan isn't technically a loan because there is no lender. You may have the ability to tap your account balance, up to certain limits, if you pay back borrowed amounts with interest and according to a set repayment schedule.
While it might seem strange to repay yourself with interest when you borrow from your own 401(k), the purpose is to compensate for lost time. When you withdraw money from a retirement account, your funds aren't invested and can't grow, which could hurt your future financial security.
The first hurdle to taking a 401(k) or 403(b) loan is that your retirement plan must allow it. If you work for a small company that offers a 401(k), many opt not to provide loans because they require paperwork and time to administer. If you're unsure whether loans are allowed for your plan, you can ask your benefits administrator or review the account's summary plan description (SPD) document, which you should receive every year.
Note that IRA-based accounts–such as a traditional IRA, Roth IRA, SEP-IRA, or SIMPLE IRA–are prohibited from offering loans.
If you can take a 401(k) loan, the IRS places a limit on the amount you can borrow over your lifetime. However, your retirement plan could impose a lower limit.
The maximum you can borrow from a workplace retirement plan is typically half your vested balance, up to $50,000. For example, if you have $60,000 vested, the maximum you can borrow is $30,000 ($60,000 x 0.5). If your vested 401(k) balance is $200,000, the most you can borrow is $50,000.
However, there may be an exception to the 50% rule if you have a small vested balance. For instance, you may be allowed to borrow up to $10,000 even if you have less than $20,000 vested. You can even take multiple loans if the total doesn't exceed your allowable limit.
Retirement account loans have an interest rate and term specified in their plan document. The repayment period is typically five years, but it may be longer if you use the 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, your 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 unpaid loan amount.
That means if you get fired or choose to leave your job and have an outstanding 401(k) loan balance, it becomes an early withdrawal unless you repay it by your tax filing deadline. Again, if you can't repay your entire retirement account loan on time, you'll have to pay income tax plus the 10% penalty if you're younger than 59.5, which could be significant.
Once you leave an employer, you become ineligible to take a 401(k) loan, even if you have money remaining in your old retirement account. If you have a new employer that offers a retirement plan, you may be eligible to roll over your old 401(k) into the new one.
LISTEN ALSO: 7 Pros and Cons of Investing in a 401(k) Retirement Plan at Work
What is a 401(k) hardship withdrawal?
Suppose your workplace retirement plan doesn't allow loans, or you need more than the allowable loan limit. In that case, you may be eligible for a "hardship" withdrawal before age 59.5 or early retirement at 55.
Hardships are specific circumstances approved by the IRS, including paying for college, buying a primary residence, avoiding foreclosure on a primary home, funeral expenses, and unreimbursed medical bills.
The downside of 401(k) hardship withdrawals 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 typically can't contribute to your retirement account for six months after taking a hardship withdrawal.
Advantages of 401(k) loans
Here are five upsides of taking a retirement account loan.
1. You borrow from yourself.
Since there is no 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. You must agree to repay the funds at a set interest rate and term.
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 don't need good credit.
Since no lender must approve you for a 401(k) loan, your credit score isn't a factor. If your retirement account allows loans, you can get one regardless of your credit rating, debt level, or household income.
3. You pay a low interest rate.
As I mentioned, the interest rate you must pay on a 401(k) loan is specified in your plan document. You must pay it to your retirement account to help make up for lost time in the markets. But the rate is typically much lower than what you'd pay for other debt, such as credit cards and personal loans.
4. You have a short repayment term.
Unless you use a 401(k) loan for a home, you typically must repay it over five years. A relatively short repayment term can help keep your financial life on track with less debt and more retirement investments.
5. You can spend it as you like.
When you take a 401(k) loan, how you spend it is entirely up to you. However, using it for a home may qualify you for a longer repayment term, such as up to 10 or 15 years. 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.
RELATED: What’s the difference between a 401(k) and a solo 401(k)
Disadvantages of 401(k) loans
Here are five downsides of a 401(k) loan to consider.
1. 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 potential investment growth during repayment. Even if you repay a 401(k) loan on time, you could end up with less than if you hadn't taken a loan.
2. Your interest is not tax-deductible.
Funds you borrow from a workplace retirement plan are tax and penalty-free if you follow all the rules–but they're not interest-free. Another consideration is that, unlike the interest you pay on a mortgage or student loan, which may be partially or fully 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 could be better off getting a mortgage or student loan. They allow you to deduct all or a portion of your interest from your taxable income, reducing your tax liability.
3. You have a lifetime limit.
As I mentioned, if your retirement plan allows loans, the maximum you can borrow is $50,000 or 50% of your vested account balance, whichever is less. There could be a lower maximum, depending on your plan rules. In addition, there may be a minimum loan amount, such as $1,000.
Your vested balance is the money you own in your retirement account. Note that you're always 100% vested in your retirement contributions. However, your employer's contributions, such as profit-sharing and matching contributions, are typically subject to a vesting schedule.
So, check your plan document or ask your benefits administrator if you're unsure how much of your 401(k) balance is vested. You'll have to look for other lending options if you need to borrow more than the allowable limit.
4. You must repay through payroll deductions.
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 or prepay your balance ahead of time.
So, be sure you can afford a potential 401(k) loan payment. Missing a payment means that your entire outstanding balance could be subject to taxes and a hefty 10% early withdrawal penalty if you're under 59.5.
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 financial hardship, you could owe a large amount of taxes and penalties. Separating from your employer for any reason when you have a retirement plan loan means your entire balance is due by your tax filing deadline.
As I mentioned, if you're younger than 59.5, any unpaid loan amounts are considered an early withdrawal, subject to income taxes plus a 10% penalty. So, be confident that your job is stable and that you plan on staying with your employer before taking a retirement account loan.
READ ALSO: How should I invest for retirement after a 401(k)?
Should you take a 401(k) loan?
Whether you should take a loan from your workplace retirement account depends on your financial circumstances and plan for using the money. Some plans require approval from a spouse for loans over a certain amount, such as $5,000.
If you have a secure job, taking a 401(k) loan at a relatively low interest rate, such as 5% or 6%, could be better than taking out a higher-rate personal loan or using expensive credit cards.
In addition to getting favorable terms when borrowing from a retirement plan for a primary home, there are special rules for active military personnel and employees who take a leave of absence.
If your retirement plan offers help from an advisor, consider discussing your situation with them. Understanding the rules and thinking carefully about the pros and cons of a 401(k) loan before tapping your retirement account is critical.
That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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