Most Common Myths About Borrowing from Your 401(k)

The 401(k) retirement plan you get at work offers more than just savings for the future. Yes, it helps you build a retirement corpus and offers significant tax advantages, but this long-term retirement vehicle can also be used to meet short-term financial needs. This does not mean making a withdrawal, which can lead to taxes and penalties. You are right to be cautious there. Instead, many plans allow you to take a loan from your 401(k).

However, before you withdraw any funds, it is important to understand the truth about borrowing from a 401(k). There is more beneath the surface than meets the eye. This article breaks down the most common myths about 401(k) loans. Let’s get started.

Below are 4 401(k) borrowing myths you must know about:

Myth #1: All 401(k)s offer a loan facility

You may assume that having a 401(k) automatically gives you a built-in emergency fund you can tap into anytime. A lot of people think of their 401(k) as a backup plan, something they can borrow from. The interest rates on 401(k) loans are usually lower than other traditional loans or credit cards, and since you are technically borrowing from yourself, it can feel safer and simpler. But this is where you need to slow down, because an important reality check is coming that you may not be ready for.

First, not all 401(k) plans offer loans. This is one of the biggest misconceptions about 401(k) loans. A 401(k) loan is not guaranteed. Whether loans are allowed or not is entirely up to your employer. Some employers include a loan option. Others do not. And if your plan does not allow loans, there is no workaround. You simply can’t take one. So, you should not assume your 401(k) will be available during a financial emergency. The only way to know for sure is to check your plan documents or ask your employer directly. This is especially important when you are starting a new job. It is something you should confirm early, not when you are already under financial stress.

Another common 401(k) borrowing myth is that you can always go back to the old account even if your current 401(k) does not offer a loan, but your previous one did. After all, it still has your money. But sadly, no. You can’t take a loan from a 401(k) tied to a job you no longer have. Once you leave a company, that 401(k) is essentially frozen when it comes to loans. Even if your previous employer’s plan allowed loans, you would not be able to take one when you leave the company. The only way around this is if you roll that old 401(k) into your current employer’s plan. And even then, it only helps if your new plan allows loans. If your current employer does not offer a loan feature, you will be stuck again. This is where people often find themselves in a bind.

So, do not treat your 401(k) like a guaranteed emergency fund. It might offer a loan option, or it might not. And even if it does today, that could change when you change jobs. So, before you rely on a 401(k) loan as part of your financial plan, confirm the rules.

Myth #2: You can withdraw all of your 401(k) money as a loan

Let’s say you have done a great job saving and you now have $500,000 sitting in your 401(k). First of all, that is impressive. Naturally, you might think that if you ever hit a financial emergency, you can simply borrow the entire amount and pay yourself back over time. After all, it is your money. You contributed to it. So you should be able to access all of it, right?

Not exactly.

The truth about borrowing from a 401(k) is that the Internal Revenue Service (IRS) places strict limits on how much you can borrow from your 401(k). You cannot withdraw your full balance as a loan. Under current IRS rules, you can borrow up to 50% of your vested account balance or $50,000, whichever is less.

So, if you have $500,000 in your 401(k), 50% of that is $250,000. But you are still capped at $50,000. So, the most you can borrow is $50,000, and not $250,000.

But if you have $50,000 saved, 50% would be $25,000. In this case, you could borrow up to $25,000.

There is also a small exception. If 50% of your vested balance is less than $10,000, you may be allowed to borrow up to $10,000. For example, if you have $15,000 in your account, 50% would be $7,500. But the rules may allow you to borrow up to $10,000 instead.

Notice the word vested. You can only borrow against the portion of your account that is fully yours. Your own contributions are always vested, but employer-matching contributions may vest over time, depending on your company’s schedule. If you are not fully vested, your available loan amount could be lower than you expect. So, even out of the $500,000 in your 401(k), you would actually have access to only the vested amount.

Hence, keep in mind that even if you see a large balance in your 401(k), you do not have unlimited access to it. The boundaries set by the IRS and your employer’s plan may affect your borrowing ability.

Myth #3: You can switch jobs before repaying the loan

Yes, you can technically keep an old 401(k) account after leaving a job. That said, it is not always ideal because managing several accounts can get confusing and harder to track. But can you keep a loan from an old 401(k) and then work at a new company?

Well, no.

In most cases, when you leave your employer, whether you quit or are let go, the remaining loan balance becomes due much sooner. You typically have a limited window to repay the full outstanding amount. If you can’t repay it within that time frame, the loan is treated as a distribution.

Now think about the practical side of this. Imagine you receive a great job offer with a better salary and better growth opportunities. But you still owe a sizable amount on your 401(k) loan. To leave comfortably, you may need to come up with a lump sum quickly to repay the loan in full. If you can’t, you risk triggering tax and penalty liabilities. This can put you in a tough position.

If you cannot pay the loan on time and take the new job, the loan will default, and the remaining balance will be considered taxable income. In this case, you will owe ordinary income tax on it. And if you are under age 59½, you will likely owe an additional 10% early withdrawal penalty on top of the taxes.

What if you lose your job instead of quitting?

Some 401(k) plans may allow additional time to repay the loan after job loss. But this can vary from employer to employer, so it is important to check your specific plan rules. However, if you are unable to repay within the allowed time, the unpaid balance is still treated as a distribution. You would owe income tax and potentially the 10% penalty on the remaining balance.

If you plan to stay with the same company, you must repay the loan within 5 years in most cases. The IRS requires that you repay the loan in payments made at least quarterly. But if you are using the loan to purchase a primary residence, some plans allow for a longer repayment period. Even then, the extended timeline depends on your employer’s specific plan. And, not every plan offers this flexibility, so you always need to check the details.

Myth #4: 401(k) loans are very expensive and must always be avoided

You have probably heard this before – Never touch your retirement money. A 401(k) loan will cost you big time. But that is only half the story. The common myth about borrowing from retirement savings is that it can cost you. But it is not automatically a terrible decision.

There are some costs associated with a 401(k) that you should know about. Let’s start with interest.

When you take a traditional personal loan from a bank, you pay interest to the bank. That money is gone. With a 401(k) loan, it works differently. The interest rate is usually based on the prime rate, which can sometimes be lower than what you would get on a personal loan or credit card. But unlike with a bank, in a 401(k) loan, you are paying that interest back to yourself. The interest you pay goes back into your own 401(k) account, since you are technically the borrower and the lender. So no, 401(k) loans are not automatically very expensive. In some situations, they may cost less than high-interest debt, such as credit cards.

But it is still a loan. The real cost is not always the interest. It is the opportunity cost. When you take money out of your 401(k), that money is no longer invested. It is not sitting in the market. It is not growing nor compounding. So, the hidden cost is what your money could have earned if it had stayed invested.

So, while a 401(k) loan is not financial suicide, you need to weigh the lower interest cost against the long-term growth you might be giving up.

The ultimate truth about borrowing from 401(k) – Is it good, is it bad?

Very few things in personal finance are completely good or completely bad. Unless, of course, you are literally setting your money on fire. But jokes apart, most decisions sit somewhere in the middle. Borrowing from your 401(k) can be helpful in certain situations. But you also lose potential investment gains.

So, is it good? It can be.

Is it bad? It can be that too.

It depends on why you are borrowing and what other options you have. There are many common myths about 401(k) loans. Some are partially true, others slightly exaggerated. Speaking with a financial advisor can help you learn more about these loans. You may explore our financial advisor directory to find vetted professionals who can help dispel your doubts about 401(k) loans.

Frequently Asked Questions (FAQs) about 401(k) loan misconceptions

1. Is a 401(k) loan the best borrowing option out there?

A 401(k) loan can be a good option because it offers relatively low interest rates, quick access to funds, and other benefits. You are also paying interest back to yourself, which can feel less stressful. That said, it is not automatically the best option in every situation. The best borrowing choice depends on your goals, financial needs, age, and income. In some cases, other options like personal loans or home equity may be more suitable. You can speak to a financial advisor about the best borrowing option for your needs.

2. If I leave my job, what happens to my 401(k) loan?

If you leave your job, most plans require you to repay the outstanding loan balance within a short period. If you can’t repay it on time, the remaining balance is treated as a distribution and becomes taxable income. If you are under age 59½, you will also owe a 10% early withdrawal penalty.

3. What if I can’t pay my 401(k) loan back within five years?

If you fail to repay the loan within the required timeframe, which is five years in most cases, the unpaid amount is considered a distribution. Once that happens, you will owe regular income taxes on the amount, plus a 10% early withdrawal penalty if you are under 59½.

4. Do other tax-advantaged accounts, like an Individual Retirement Account (IRA) or a 529 college savings plan, offer loans?

No, they generally do not. Unlike many 401(k) plans, IRAs do not allow you to take loans from your account. If you withdraw money, it is considered a distribution, not a loan. It may trigger taxes and a 10% early withdrawal penalty if you are under age 59½. 529 college savings plans also do not offer loans. If you take money out for non-qualified education expenses, the earnings portion of the withdrawal will be subject to income tax and a 10% penalty.

For additional information on retirement planning strategies that can be tailored to your specific financial needs and goals, visit Dash Investments or email me directly at dash@dashinvestments.com.

About Dash Investments

Dash Investments is privately owned by Jonathan Dash and is an independent investment advisory firm that manages private client accounts for individuals and families across America. As an SEC-registered investment advisor (RIA) firm, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services tailored to each client’s unique needs, providing institutional-caliber money management based on a solid, proven research approach. Additionally, each client receives comprehensive financial planning to help them move toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been covered in major business publications such as Barron’s, The Wall Street Journal, and The New York Times as a leader in the investment industry with a track record of creating value for his firm’s clients.