Pros and Cons of Borrowing a Loan Against Your 401K Account - Retirement Planning

You may have a number of financial needs in life. Some of these can be accomplished with savings, some with your investment returns, and others through loans. While opting for debt is generally not recommended, especially for non-essential expenses, sometimes it can be the only option. More significant purchases like real estate can require you to take the debt route because of the high purchase values. Likewise, an unexpected financial emergency, such as health issues, home repairs, personal issues, etc., can also create financial troubles. A loan can be the only option here.

Most banks offer loans. You can also apply for a loan from a Non-Bank Financial Company (NBFC). The rate of interest can differ for different lenders. Moreover, the rules, tenures, and eligibility criteria are also unique for every lender. So, it is vital to check these. Banks and NBFCs can be convenient options. However, they would check your credit score, employment status, and other financial statements before offering you a loan. If you wish to avoid this intricate process, you have another option – borrowing from your 401k. The 401k retirement account is a company-sponsored plan that offers you the option to take a loan against your funds. As convenient as this option may sound, it does have its pros and cons that you must know and understand before you go ahead and apply for a loan. It is advised that you consult with a professional financial advisor about the different benefits and drawbacks of borrowing from a 401k before going down this route. Keep reading to understand these in detail.

What is a 401k loan?

A 401k loan is a loan against your 401k account. Borrowing against 401k can be an effective way to cater to your immediate needs and financial emergencies. Essentially, you borrow from yourself as it is your own money that is given to you in the form of a loan. However, the borrowed sum is considered a loan and is treated like any other loan. There is a rate of interest, tenure, and a repayment schedule that you must follow.

As of 2022, you can borrow up to $50,000 or 50% of the total amount of the 401(k) account, whichever is lower. Moreover, the maximum tenure for a 401k loan is only five years. So, you must repay the borrowed sum within five years. If not, you will be penalized by the Internal Revenue Service (IRS), and your loan will be considered a withdrawal. However, the IRS does offer some relaxations in the repayment rules in some exceptional cases, such as:

If you take a loan for unreimbursed medical expenses
If you are a first-time home purchaser
If you use the funds for qualified educational expenses
In the case of a disability
If the 401(k) plan owner is deceased

Further, some 401k administrators may require spousal consent to pass a loan.

How to borrow from a 401k

The process of borrowing funds can differ from organization to organization. Therefore, talking to your company and understanding the procedure is essential. Typically, most companies may ask you to follow the steps given below:

1. Talk to your employer:

Submit a request for a loan to your employer. You can do so by signing in on your company’s web portal, sending an official email, or talking to your manager in person.

2. Fill in the necessary documents:

Fill in all required documents and submit any relevant copies of your personal and financial details. The application form will also contain details like the loan amount, tenure, rate of interest, etc. Go through these carefully. You may also be asked to submit identification proof, bank statements, etc.

3. Receive the funds:

After the verification is complete, the funds will be credited to your account. You can then use them as you see fit.

Once you have received the funds, the loan’s term will start. Make sure to make regular repayments as per your loan’s terms and conditions. Additionally, keep in mind that borrowing against a 401k should not put an end to your investments. So, it is also important to keep contributing to your plan as before.

What are the pros and cons of taking a 401k loan?

Taking a loan from a 401k account is one of the easiest options. However, it does have some advantages and disadvantages. Let’s see what these are:

Pros of borrowing from 401k

Here are some advantages of taking a 401k loan:

Quick access to money: A 401k loan can be processed quickly. Since you are technically the lender and the borrower, the procedure requires fewer checks, verifications, and other formalities. You can apply to your employer and receive the funds in a matter of a few days. There is no need to get a third-party involved.
Flexible repayment options: The 401k loan has to be paid within five years. However, plan administrators provide flexible repayment options within these five years, such as prepayment. In most cases, there is no prepayment fee either. However, the rules for taking a loan from 401k can differ for different companies and employees. So, it may still be advised to confirm this with your employer.
Retirement savings can still flourish: Debt is generally seen as a blockage in your path to financial freedom. However, a 401k loan can be different. When you take funds from your 401k, you essentially borrow from yourself, and you have to repay yourself. Therefore, your financial growth does not stop. You do pay interest. However, the interest, in some ways, makes up for the lag in your retirement savings. So, your retirement planning goes on at a slower but still steady pace.
No credit check: A 401k loan does not require a credit check. You can avail of a loan irrespective of whether you have a high or a low credit score. This opens up an opportunity even if you have been struggling to find a loan outside. Further, a 401k loan is not counted in your credit score. So, your credit score will stay unaffected even after borrowing from a 401k.

Cons of borrowing against a 401k account

Even with the many pros, there are some things to be wary of when taking a 401k loan. These include the following:

Forfeiting potential gains: When you take a loan, you take out money from the market to fulfill your immediate needs. You rob your money of the opportunity to grow and earn returns. This impacts your overall returns at maturity and affects your retirement planning targets.
The employer may refuse: A 401k loan is not provided by all employers. In some cases, the employer may not offer a loan. In some companies, loans may only be provided to higher management. If your employer refuses to give you a loan, you would have to resort to another option.
Limited loan options: The IRS has put a limit of $50,000 or 50% of the total loan amount, whichever is lower. You cannot apply for a loan higher than this. If you need more funds, you would have to use the 401k partially and apply for a loan outside. In addition to this, you can only take a loan from your current employer. If you quit your old company and leave the 401k there, you would not be able to take a loan. You can do so only if you roll over the money to the new employer.
Short repayment term: The repayment term for a 401k is only five years. If you are unable to clear the loan within this time, you will owe a penalty and tax on the entire loan amount. Unpaid loans are considered distributions by the IRS, implying that you would have to pay a 10% penalty and applicable income tax on the loan if you are under the age of 59.5 years.
Hassles of quitting your job: If you take a 401k loan, you will not be able to quit your job unless you repay the loan. In this case, the tenure of five years will not be considered. Instead, you would have to clear your outstanding balance before quitting until the due date of your federal income tax return. This can be highly problematic and stressful if you do not have the required funds.
Possibility of taxes and penalties: The failure to pay back the loan can create trouble in the form of taxes and penalties. If you do not settle the loan, you will pay a 10% penalty and income tax on the money. This can come in the way of your financial planning and other needs.

Should you take a 401k loan?

Borrowing against a 401k can have its advantages and disadvantages. There is no way to say what is right and what is not, as everyone’s situation and needs will differ. However, it is crucial to carefully evaluate your requirements, other loan options, your employment status, and other similar factors before taking a call.

Usually, borrowing from a 401k may be recommended in the case of small loan amounts. These can be paid quickly and do not tie you up to a job. The smaller the loan amount, the sooner you can pay it off and switch positions. Further, a 401k loan makes for a good choice if you have a substantial, sudden need for cash, such as for home repair, a medical emergency, etc. It is not advised to take 401k loans for non-essential expenses. It is also not recommended for long-term needs, as those can be met with optimal investments and savings.

Alternatives to 401k loans

There are several other options that you can consider in place of 401k loans. These can include:

1. Emergency funds:

It is always advised to maintain an emergency fund to cater to unexpected needs and avoid dependence on loans. An emergency fund can help you cover expenses and remove the need for a 401k loan.

2. Home equity loans:

A home equity loan uses the equity in your home as collateral. The lender offers you a loan based on your home’s value. The interest rates are relatively lower because the loan is backed by the security of collateral. Moreover, home equity loans can also be used for higher cash requirements.

3. Personal loans:

Personal loans offer greater flexibility than most other loans. These can be used for a vast number of needs, such as travel, buying electronics, home renovation, starting a business, etc. However, your credit score will play a role in the rate of interest.

4. Savings and investments:

You may consider liquidating some of your investments or savings for immediate needs. Stocks, mutual funds, exchange-traded funds, etc., offer immediate redemption without any penalties. However, they do trigger your tax liabilities. So, make a decision after analyzing all aspects of this choice.

5. Credit cards:

Just like personal loans, credit cards can also be used for varied expenses. They are easily accessible, simple to use and provide instant funds without any formalities. You can consider getting a new credit card to avail of introductory interest rate offers and save money too. If not, you can use your existing credit card. No matter what you choose, make sure to pay attention to compare the interest rates of different cards and then pick one. Additionally, also bear in mind that your credit card debt will impact your credit card.

To conclude

Borrowing against a 401k is a common practice. Many employees use this credit option to fulfill their immediate financial needs. However, it is essential to understand that your loans can have some short and long-term ramifications. It is also important to recognize that your 401k is primarily a retirement account. Therefore, it may be better not to use it for other goals and reserve it distinctly for retirement. If at all you need funds due to factors out of your control, you may use your 401k, but make sure to plan your career, job switches, etc., around it. Also, make sure to repay the loan on time to avoid the 10% penalty and taxes.

If you are still unsure whether to opt for a 401k loan, you can talk to a professional financial advisor in your area and get more clarity. Use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.

For further information on suitable investing and saving strategies for your retirement needs, 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, managing private client accounts for individuals and families across America. As a Registered Investment Advisor (RIA) firm with the SEC, they are fiduciaries who put clients’ interests ahead of everything else.

Dash Investments offers a full range of investment advisory and financial services, which are tailored to each client’s unique needs providing institutional-caliber money management services that are based upon a solid, proven research approach. In addition, each client receives comprehensive financial planning to ensure they are moving toward their financial goals.

CEO & Chief Investment Officer Jonathan Dash has been profiled by The Wall Street Journal, Barron’s, and CNBC as a leader in the investment industry with a track record of creating value for his firm’s clients.