mp
Arrow

Taking a Personal Loan from your 401(k)?

Author image
Len Penzo
Taking a Personal Loan from your 401(k)?

While we often think of our 401(k) account as a financial sink, there are occasions where it can be borrowed from to create a useful loan.

When properly employed, this can help fund important purchases and cover unexpected costs, but some key elements need to be considered first.

What Exactly is a 401(k) Loan?

A 401(k) loan is a form of borrowing that takes directly from your retirement account. This means that any money taken from this loan is going to directly affect the amount of savings you have in this account, which will have to be paid back in a timely manner.

Such loans are not universally available, with some businesses putting strict limits on them or prohibiting them completely.

As with other loans, payments to this account have to be made quick, and they also incur a cost in the form of interest. For these reasons, borrowing against a 401(k) should not be a decision made casually.

What are the Limits on Borrowing from 401(k)?

The limits on borrowing from 401(k) loans depend on two different factors, that of the business which employs you and the maximum amount as set by the IRS. The limits as set by the IRS exist as either 50% of your total balance, or $10,000, whichever amount is greater.

It is also important to note that, at the highest level, you can borrow a maximum of $50,000 and no more.

For example, a person with $14,000 could borrow a maximum of $10,000, according to the above rules. With these same rules, a person with $40,000 could borrow a maximum of $20,000, and somebody with 401(k) savings of $130,000 would max out at $50,000.

When do you have to Pay Back a 401(k) Loan?

While different plans might be selectable based on your employer, the general upper-limit repayment time of a 401(k) is five years. These repayments must be made at least quarterly in substantial amounts that include interest as well as the principal quantity owed. These can be made separately from your employment or might be included through payroll deduction.

As for the interest rate, this again depends on your individual plan, with the typical interest percentage being dictated by the current prime rate. On most occasions, the percentage of interest expected should be similar to that as found with a typical bank loan.

When are 401(k) Loans Useful? 100 words

There are many reasons why somebody might take out a 401(k) loan. The most common of these are using at 401(k) for a down payment on a house, though it’s possible to use a 401(k) as a down payment on many other necessities such as vehicles.

Other common uses of 401(k) loans include:

  • Paying medical debt
  • Repaying the IRS through back taxes or another means
  • Funding education costs
  • Using it as a home improvement loan

It's important to note that it’s not possible to use a 401(k) as collateral for another loan. Potential borrowers should also keep in mind that no credit check is involved with a 401(k) loan, so they may find it much easier to qualify compared to an alternative loan if you have a poor credit score .

The Issue of Lost Retirement Savings

A lack of retirement savings is an issue that affects people of all ages, though current studies suggest the problem is much more notable among younger generations. Because of this, taking out a personal loan through a 401(k) could prove a major hamper on financial security further down the line.

Furthermore, debt to income ratio is also a major issue that is affecting these younger generations more than ever, with the real purchasing power of the dollar having dropped significantly over the last couple of generations.

Taking these different components into account, the problem of lost retirement savings becomes all the more pronounced. Not only are people today suffering from increased debt, but their money is also worth less than it has been before. Removing money from a 401(k) now only means a smaller final retirement amount decades from now.

It also means that borrowers could miss out on the benefits of lower income taxes which are placed on 401(k) contributions.

However, borrowers should similarly consider that money placed with 401(k) accounts continually generates interest. That means that, even when adjusted for inflation, a final 401(k) will be worth more than what has been initially placed into it. The greater the 401(k) account, the more interest that will be continually secured.

Is it Worth Quitting your Job?

Employment can be fickle, and opportunities or realities within life can often force people to make enormous and unplanned changes. Sometimes, this can mean having to quit a job or getting fired, and this can create complications for those who have outstanding 401(k) loans.

In any of these instances, employees will be required to repay their outstanding loans when the time comes to file their next tax return. While you can carry this debt over into another retirement account, this isn’t always a viable option. In this case, where repayments cannot be made, you would be required to pay a 10% penalty on the total amount owed.

Given these realities, a loan is only recommended if your life is otherwise steady, if employment or backup employment is guaranteed, and if other relevant general financial concerns have been addressed pre-emptively.

What Other Choices Exist? 

If you’re unsure about whether you meet the safety criteria listed above, then common alternatives can be a much safer avenue of pursuit. The most popular of these are personal loans, home equity loans, and taxable withdrawals.

Personal loans are best utilized if you have a good credit score. In such situations, it can be quite possible to find loans with generous terms that can be used to pay for a wide range of goods and services. Since these can also be unsecured, it’s sometimes not necessary to put down collateral.

Home equity loans can be a good choice if your home has considerable or reliable worth. Should one of these loans be put towards home improvement or repairs, they can also be written off as tax-deductible.

Taxable withdrawals from a 401(k) are another option in place of 401(k) loans. For such withdrawals, it can be possible to find exemptions for potential problems, like the 10% failure penalty. Just keep in mind that such withdrawals also come with their own heavy sets of requirements, which should be fully investigated before this path is considered or accepted.