Borrowing against your 401(k)

Can you borrow from your 401(k)?

The short answer is, yes. While the primary purpose of a 401(k) plan is to provide a tax-advantaged way to save for retirement, many plans allow investors to borrow against their contributions. Although this type of loan can provide fast access to funds, it also comes with important rules and tradeoffs that should be carefully considered.

401(k) loan vs. withdrawal

When tapping into your 401(k) for cash, you can expect significant differences between a loan and a withdrawal. A major difference is that a withdrawal doesn’t have to be repaid while a loan is repaid with interest (although you’re paying the interest to yourself). A loan does not trigger taxes as long as the repayment terms are met, while a withdrawal is taxed as ordinary income and will come with a 10% early withdrawal penalty unless certain exceptions are met (more on that later). Here’s a summary of the most common differences between 401(k) loans and withdrawals:

Generally, a 401(k) loan is considered more advantageous than an early withdrawal because it avoids taxes and penalties. However, 401(k) withdrawals don’t always incur penalties. Two exceptions are available:

• Hardship withdrawals—If the withdrawal meets the IRS requirements for hardship, penalties will not be charged. Disability and certain medical expenses may also meet the exemption from penalties. However, it’s important to note that hardship withdrawals are subject to taxes.
• The rule of 55—This exception states that a 401(k) can be cashed out without penalty if the owner leaves their job at age 55 or older and cashes out the 401(k) that same year.

How to borrow from your 401(k): Rules explained

Although taking a loan against your 401(k) is easier than obtaining a conventional loan, it involves strict IRS and plan-specific guidelines. Understanding these rules can help prevent costly mistakes.

Eligibility

401(k) plans are not required to allow loans. If your plan permits loans, you must be actively employed by the plan sponsor, and you can only borrow against your vested balance.

Loan limits

You can borrow up to $50,000 or 50% of your vested 401(k) balance, whichever is less. If you have less than $10,000 in the plan, then $10,000 is the maximum you can borrow. Some plans require smaller limits.

Interest rates

The interest rate on a 401(k) loan is usually 1%-2% above the prime rate.

Repayment terms

The typical 401(k) loan must be repaid within 5 years. Some plans allow a longer repayment period when the loan is for the purchase of a home.

Leaving your job

In most cases, leaving your job requires complete repayment of the loan within 60 days. If not repaid, the loan becomes a taxable distribution, and if you’re under the age of 59½, a 10% penalty may apply.

Why would a 401(k) loan be denied?

A 401(k) loan can be denied for the following reasons:

• The plan does not permit loans.
• The maximum loan amount against your account has already been reached.
• You have defaulted on a previous loan from the account.
• Your vested balance is too low.

Pros and cons of taking a loan from your 401(k)

Every decision has tradeoffs, and a 401(k) loan is no exception. Understanding the implications of a loan and taking a close look at your situation will help you make the best decision. Speaking with a financial professional can help you make a plan that balances your current needs with future goals.

Pros of borrowing from your 401(k)

• Ease of borrowing—401(k) loans provide fast access to cash with no credit check and no effect on your credit score.
• Lower interest rates—The rates on a 401(k) loan are usually lower than the rates on conventional loans.
• Retained interest—While you pay interest on a 401(k) loan, that money goes into your account, which lessens the impact on your retirement savings.

Cons of borrowing against your 401(k)

• Missed growth opportunities—The money that’s removed from your 401(k) cannot continue to grow tax-deferred and misses out on the benefit of the compound interest it could have made if not removed from the account. You’re also replenishing the account with post-tax dollars.
• Risks from unemployment—If you leave your job, your exit triggers a mandatory full repayment (usually 60 days). You may be able to avoid the accelerated repayment with a 401(k) rollover, meaning you must roll over the balance in the account to a new 401(k).
• Risk of default—Although you’re paying yourself back when you repay a 401(k) loan, a default carries significant consequences. The defaulted loan converts to a 401(k) withdrawal. The taxes and early withdrawal penalty that was avoided with the loan, now go into effect. Making payments through payroll deductions, if you have the option, may help you avoid a default.
• Temptation to pause investing—It may be tempting to pause investing while you repay your 401(k) loan. Putting a hold on investing can affect your long-term finances because of the missed opportunity for strategies like dollar cost averaging, which require continued market participation. Although it may be challenging, it’s best to keep investing whenever possible.

Alternatives to borrowing from your 401(k)

Before using retirement funds, it’s wise to explore other options that may better protect your long-term financial security. Some of the most common options include:

• Emergency savings—If available, emergency savings are often the least risky option. These funds are designed for unexpected expenses and won’t disrupt retirement growth. It is crucial, however, to rebuild the fund, so that you have a cushion for any future needs.
• Home equity loans—Home equity lines of credit (HELOCs) tend to offer lower interest rates, longer repayment terms, and depending on their use, the interest payments may be tax deductible.
• Personal loans—If you’re not a property owner, a personal loan may be a good option for accessing cash.
• Cash value life insurance – For individuals seeking flexible access to cash value without jeopardizing retirement accounts, cash value life insurance can be especially helpful. They generally provide tax-free access to cash and have no required repayment schedule as long as certain conditions are met.
• Debt consolidation—If seeking to ease the burden of high-interest debt, consolidating balances under a lower interest loan or 0% credit card may be helpful. Be careful to check the terms on a 0% card since the rate may only be applicable for a set time.
• Same as cash loans—Promotional offers that allow you to purchase goods on 0% interest payment plans can be useful. Just be sure to pay off the full amount by the required date because interest rates tend to be high and the interest is usually calculated from the purchase date.

Related: Guaranteed future income with deferred income annuities

Borrowing against your 401(k) can be a useful short-term solution, but it shouldn’t be a first choice. Understanding the rules, risks, and alternatives can help you make a choice that both supports your immediate needs and keeps your retirement plans on track.

Borrowing against your 401(k)

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Neither New York Life Insurance Company nor its Agents provide personal tax advice. Please consult with your tax adviser to find out whether the general concepts in this article apply to your personal circumstances.