How to Borrow from a 401k – Your Money, When You Need It
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Many years ago, when I was just starting to fund my 401k retirement plan at work, a woman I worked with did something that I thought was crazy: she withdrew money from her retirement account to remodel her home.
She paid a 10% early withdrawal penalty because she was much younger than 59-1/2, and she had to report the withdrawal as taxable income when she and her husband filed their taxes.
I don’t know how much money she withdrew, but I thought it was a bad idea for a few reasons. Along with the penalty and possibly increasing her income tax, she lost the compounding of the money she withdrew. Her retirement account could be tens of thousands of dollars lower at retirement age.
Borrowing money from her 401k would have been better, though I thought taking any money out of a retirement account before retirement age was still a bad idea and should have been the last resort.
Such expenses are what an emergency fund is for, a credit card or another type of loan. And really, was a home remodel an emergency expense? Medical expenses, I can see, but taking money from your future self to fix up your home? That didn’t make sense.
After years of funding my own retirement savings and writing about personal finance, I’ve concluded that her money move probably wasn’t so bad for several reasons. To start, her spending priorities are different from mine, or at least they were at that time, so I shouldn’t judge her decision.
If it makes sense to her to take money out of her retirement plan while paying a 10% penalty and adding to her regular income for the year, then it’s the right move. But there are less financially painful ways to do it.
Related: How To Make the Most of Your 401k
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How to borrow from 401k
A 401k is an employer-sponsored retirement plan for workers to move pre-tax dollars, or after-tax dollars in a Roth 401k, from their paychecks to their retirement savings.
Money can be pulled from these plans, though some taxes and penalties will likely be charged, and the retirement account balance will drop if the 401k loan isn’t repaid. If your plan administrator allows it, you can borrow from your vested account balance if you repay the loan, plus interest, within five years.
We’ll go over how a loan from a retirement account works, how straight withdrawals work before retirement age, how much a retirement account balance can drop from an early withdrawal vs. a loan, and other options for getting cash you need now for short-term needs while still preparing for the long-term.
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Early withdrawals are a worse option
Before we go over how to borrow from a 401k, another option to be aware of is withdrawing money from it under a hardship withdrawal. The money you pull out of your retirement savings doesn’t have to be paid back.
There are two expenses:
- You won’t get the full amount you want to withdraw because withdrawals from 401k accounts are generally taxed as ordinary income.
- A 10% early withdrawal penalty applies before age 59 1/2 unless you meet one of the IRS exceptions.
The IRS considers a hardship for such a withdrawal to be an immediate and heavy financial need for medical expenses, foreclosure, tuition payments, funeral expenses, and costs related to purchasing and repairing your primary residence, though mortgage payments are excluded. Not all retirement plans allow hardship withdrawals.
A 401k loan
Some employer plans allow a 401k loan of up to $50,000 or half of your vested account balance, whichever is less. The loan term is normally five years.
In most cases, the outstanding loan balance must be repaid, plus interest, within five years. The interest rate you pay must be market interest rates, making the loan comparable to what a conventional lender would charge on a personal loan of the same amount.
You may need your spouse’s or domestic partner’s consent to take out the loan. The plan may have rules set a maximum number of loans that can be outstanding at once.
You’re basically borrowing money from yourself. One disadvantage, however, is you’ll be repaying the pre-tax funds with after-tax earnings. This can mean working more hours to earn the after-tax money to repay the loan. Also, those after-tax dollars will be taxed again when you withdraw them from your account during retirement.
If you don’t make loan repayments on time, the loan could be considered in default and is considered a distribution. Tax penalties would then be charged.
You can’t borrow a 401k plan from a company you no longer work for. However, if you rolled that money into your current 401k, you can borrow from that account.
Besides being able to borrow money, the best part of a 401k loan is that it doesn’t require paying taxes and penalties, as long as repayment is made on time. If you do miss a loan payment, it won’t affect your credit score because defaulted loans aren’t reported to credit bureaus.
But a missed payment can lead to loan default when you then owe taxes because it’s now taxable income, and you’ll be charged a 10% penalty if you’re under 59-1/2.
If you quit your job before paying off the loan, you’ll have to repay the balance by the due date of your federal income tax return. An older rule required repayment within two months of leaving a job. Loan payments are normally made through payroll deductions.
Use Bankrate to Get a Personal Loan
- Get as much as $100,000 with rates starting at 5.95% APR*
- Use a personal loan to pay off debt, renovate your home, family needs, and more
- Takes minutes to see how much you can get
- Doesn't hurt your credit score to check
Financial impact of the loan vs. withdrawal
Fidelity gives a good example of a hypothetical loan scenario vs. a withdrawal from a 401k to show how an account balance is affected.
Impact of taking $15,000 from $38,000 account balance
Type of withdrawal | Taxes and penalties | What you get | What’s left in 401k |
Loan | $0 | $15,000 | $23,000 |
Withdrawal and penalties | $8,810 | $15,000, but need to take out $23,810 to cover taxes | $14,190 |
The withdrawal scenario’s taxes and penalties break down to 20% for federal taxes, 7% for state taxes, and a 10% early withdrawal penalty for 37%. A total of $23,810 is taken from the account so that 37% ($8,810) of the withdrawal is set aside for taxes and penalties, and the remainder ($15,000) is received, leaving $14,190 in the remaining balance.
Someone who made the withdrawal at age 45 would have $66,812 less when they retire at age 67 than if they repaid the loan.
With a retirement account balance of $38,000 at age 45, and age 67, the loan would put the balance at $429,725, according to Fidelity. A withdrawal would result in a 401(k) balance of $362,913 at age 67 or a potential gap of $66,812.
Good reasons to borrow
As we described earlier, immediate and heavy financial need hardship withdrawals are often required for early 401k withdrawals. These include medical expenses and repairing your home. Employers may want to know what you’re using the loan proceeds for.
Either way, pulling money from a retirement account early means less money invested in an account meant to pay for your long-term needs in retirement.
Borrowing money from a 401k for a vacation or to buy wedding gifts is a bad idea and one your employer may not allow.
But if the loan helps your overall finances in the long term, you may want to consider it if you don’t have better options. For example, paying off high-interest credit cards can help you get out of debt and save you a lot of money.
And since 401k loans don’t require a credit check, they won’t appear as debt on your credit report and thus won’t affect your credit score.
Home improvements can also be another smart way to use a retirement account. The projects may raise the value of your home enough to offset the fact that you’re paying the loan back with after-tax money and lowering your retirement savings.
To combat that loss, you should pay off the loan on time and in full, continue saving for retirement, and don’t borrow more than you need or too many times.
Other options
A 401k loan or withdrawal should be your last resort when looking for a large amount of cash. Both can substantially lower your retirement plan balance, with a withdrawal creating a larger loss by the time you retire.
Here are some alternatives to consider:
- Emergency fund
- Health Savings Account for qualified medical expenses
- Low or zero interest balance-transfer credit card to move high-interest credit card balances to
- Home equity line of credit
- Home equity loan
- Personal loan
- Non-retirement savings such as checking, savings, and brokerage accounts
- Withdrawing from a Roth IRA can be done anytime without paying taxes or penalties
Costs
The costs of borrowing from or withdrawing from a 401k are straightforward.
A loan’s interest rate will be set at current rates. You won’t be charged taxes and penalties if you repay the loan.
However, if you miss payments and the loan goes into default, you’ll pay a 10% penalty if you’re under 59 1/2 years old, and the loan will be treated as income, and you’ll have to pay income tax on it as earnings. According to Fidelity, you plan on paying 20% of the loan in federal taxes and 7% in state taxes if you default on the loan.
If you withdraw money before age 59 1/2, a 10% early withdrawal penalty applies. No matter your age, taxes must be paid on the withdrawal, which can be about 27% of the amount you took.
Pros and cons
Pros
- A 401k loan is often better than a traditional hardship withdrawal.
- You can get money for an emergency or just about any need fairly quickly if your employer allows 401k loans.
- A loan allows you to pay yourself back over time with interest.
- Up to half of your retirement savings account can be borrowed, up to $50,000.
- No taxes or penalties are paid on a 401k loan.
- The loan can be repaid early with no prepayment penalty.
- Payroll deductions are usually used to repay the loan within five years.
Cons
- Loan may have to be repaid quickly if you change jobs.
- If you can’t repay the loan, it’s in default and considered a distribution, so you’ll owe taxes.
- A defaulted loan can also mean paying a 10% penalty if younger than 59 1/2.
- Repayments are made with after-tax dollars that will be taxed again when you withdraw them in retirement.
- Even though you pay yourself back with a 401k loan, you’re still removing money from a retirement account that’s growing tax-free, giving you less money to grow over time.
- Even when you pay the money back, it has less time to fully grow.
- You can’t borrow from an old 401k from a company you no longer work for unless you’ve rolled it into your current 401k.
The bottom line
If you need a large amount of money for a big expense and don’t have an emergency fund, can’t get a personal loan, or don’t have another funding source, then a 401(k) loan may be your best option.
As a last resort, it allows a loan for a maximum amount of $50,000 with a repayment period of up to five years at an interest rate compared to other loans. One of the best parts of borrowing from your retirement account is that the interest you pay goes back into your retirement savings. You’re paying yourself back with interest.
Your retirement plans may take a hit because the loan leaves you with less money to invest and less time for it to grow, but your immediate financial need will be met. Vanquishing a money problem with a loan you repay to your future self may be the best gift you can give yourself.
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Writer
Aaron Crowe is a freelance journalist who specializes in personal finance writing and editing. He has worked at newspapers, where he won a Pulitzer Prize, and has written for numerous online publications. These include AOL, US News & World Report, WiseBread, Bankrate, AARP, and many websites focusing on housing, credit and insurance. He lives in California with his wife and daughter.
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