Borrowing from your 401(k): The risks

Amy Fontinelle

By Amy Fontinelle
Amy Fontinelle is a personal finance writer focusing on budgeting, credit cards, mortgages, real estate, investing, and other topics.
Posted on Mar 27, 2020

Starting to save for retirement at a young age is one of the smartest steps you can take to ensure your future financial security, so is it worth jeopardizing that security by borrowing from your 401(k)? Many people do … and at a relatively early age.

According to a 2019 survey by MagnifyMoney, 54 percent of millennial savers say they have taken an early withdrawal from a retirement savings account, compared with 50 percent of Gen Xers and 43 percent of baby boomers. Millennials are also more likely to say that raiding your retirement fund is justified under certain circumstances.

Here’s a look at the pros and cons of taking out a 401(k) loan in a financial emergency.

Is borrowing from your 401(k) an option?

Employer plan sponsors are not required to allow for 401(k) loans, but roughly half do, according to Employee Benefit Research Institute (EBRI). Plan participants can read their 401(k)’s summary plan description (SPD) to find out if they are eligible to take loans from their own plan. If so, the SPD will state the company’s loan terms, which must fall within IRS guidelines. Employees can also check with their human resources department.

The IRS limits how much workers may borrow from their 401(k) plans. In the past, employer plan sponsors have not been permitted to allow plan participants to borrow more than: 1) the greater of $10,000 or 50 percent of their vested account balance; or 2) $50,000, whichever is less. In other words, if your vested 401(k) balance is $60,000, you were only able to potentially borrow up to $30,000. If your vested balance is $120,000, you may have been able to borrow up to $50,000.

But the CARES Act stimulus bill, passed by Congress in March 2020 to help both working Americans and employers withstand the financial toll wrought by the coronavirus pandemic, relaxed many of the rules related to both retirement plan loans and outright withdrawals. For participants in eligible retirement plans, the legislation raises the limit on 401(k) (and other eligible retirement plans) loans to the lesser of $100,000 or the vested account balance.

Generally, the IRS requires retirement plan borrowers to make substantially equal loan repayments at least once per quarter, and those payments must include both principal and interest. You cannot take more than five years to repay the loan (unless the loan is specifically for the purchase of a primary residence, which allows for a longer payback period).

One of the perks of borrowing from a 401(k) plan, or its nonprofit- and public-sector equivalents, the 403(b) or 457(b) plans, is that unlike commercial loans, they do not require a credit check, so they are available even to those with unfavorable credit scores.

Also, while your goal should be to repay your 401(k) loan in full and on time, if you do default, it will not hurt your credit score.

They are also an available source of liquidity in a pinch, unlike other retirement accounts. Indeed, the IRS does not permit loans from Individual Retirement Accounts (IRA)s. Any distribution from an IRA before age 59-1/2 is subject to ordinary income taxes, plus a 10 percent early withdrawal penalty. (The CARES Act does allow for penalty-free distributions from qualified retirement plans, including IRAs, of up to $100,000 for 2020 for those experiencing hardship as a result of the coronavirus pandemic.)

When a 401(k) loan may make sense

About one-fifth (19 percent) of all 401(k) plan participants who had the option to borrow from their plans had a 401(k) loan outstanding at the end of 2016, according to EBRI. The average unpaid balance was $7,907 and the median loan balance outstanding was $4,279.

Most financial professionals, however, insist that those saving for their retirement only tap their 401(k) as a last resort. (Related: Four reasons why your 401(k) may not be enough)

“The reason is that this money is specifically for use when you are not working,” said IRS enrolled agent and chartered retirement planning counselor Abby Eisenkraft, CEO of Choice Tax Solutions in New York City. “If you are young, working, and can't save, what happens when you are older and not working? Social security hardly covers rent for most people, and for others with a paid up mortgage, there are still real estate taxes and other large expenses.”

Another problem has to do with taxes.

Because participants contribute pretax dollars to a 401(k) plan, but repay a 401(k) loan with after-tax dollars and also pay taxes when they take distributions from the plan, participants essentially pay taxes twice on the loan amount, said Pamela Bobersky, a qualified 401(k) administrator and president of AMI Benefit Plan Administrators in Youngstown, Ohio. Further, many plans charge a fee to take out the loan and a fee to maintain the loan.

Make sure you are borrowing because of a true emergency, such as not being able to pay your rent and not being able to downsize to a less expensive residence.

Yes, people do borrow from their retirement savings to buy a home, to finance an education, to start a business or to take a vacation. But these aren’t always good reasons to borrow from a 401(k). And in some cases, there may be better ways to borrow — better because they’re less expensive or because they’re less likely to impact your retirement. In other cases, borrowing means you’re living beyond your means and should try to solve that problem without taking out any kind of loan. (Calculator: How much should I save for retirement?)

That said, if you have no way to cut your expenses, a 401(k) loan might make sense. Further, if you have bad credit and can’t get a commercial loan at a low interest rate, a 401(k) loan may be your best option.

But the math has to make sense for your individual situation. If you’d lose 6 percent per year in investment earnings by borrowing from your 401(k), but you’d avoid paying 20 percent interest on a personal loan or credit card balance, the 401(k) loan will be less expensive. What’s more, if the interest you pay on your 401(k) loan is equal to or greater than the investment earnings you miss out on by taking a 401(k) loan, the loan will not hurt you in the long run.

What you could lose when you borrow from your 401(k)

Don’t take a 401(k) loan if you don’t have the discipline and the financial means to repay it.

Eisenkraft said that the same behavior that got a person into trouble in the first place will often continue unless they make a conscious effort to change. (Related: Managing debt in a balanced way)

But Bobersky said repaying the loan is not normally a problem because many plans require loan repayment through payroll deductions. “The issue is that many participants decrease their contribution amounts to the plan during the time of repayment, making it harder to reach their retirement goals,” she said.

Indeed, a 2015 study from Fidelity found that about a quarter of participants who borrow from their 401(k)s make lower contributions or no contributions after taking out a loan. This finding makes sense, since people who take out 401(k) loans are struggling financially and repaying a loan leaves fewer resources to contribute to retirement.

Failing to contribute to your 401(k) for any period of time is a missed opportunity that you’ll never get back, though. And if your company matches a percentage of retirement contributions, there’s the added problem of leaving money on the table. So if at all possible, and if your plan allows it, keep making contributions to your retirement savings account at the same rate while you’re repaying your loan.

But at the very least make sure to repay your loan. Why? Failure to repay your loan balance on time will be considered a distribution and you will owe taxes (at your marginal income tax rate) and a 10 percent early withdrawal penalty if you are younger than age 59-1/2 on the amount you have not paid back.

While you’ll have to pay taxes on any 401(k) withdrawal eventually, even if you wait until retirement age, the penalties are a waste of money. Further, never paying yourself back could significantly hurt your long-term net worth. The money you take out won’t be earning investment returns and compounding. Agreeing to repay your loan through automatic payroll deductions can help keep you honest.

Generally speaking, financial professionals suggest retirement savers avoid taking out a 401(k) plan loan if a layoff, job change, or company acquisition seems imminent, because any of these events could mean that you would have to repay your loan in full within a certain time period — an obligation you might not be in a position to fulfill, turning the unpaid loan balance into a distribution.

Another potential problem with 401(k) borrowing arises if you must sell investments at a loss to borrow money. It is one thing to lose money on paper when the stock market is down; it’s another to make those losses real by selling your investments.

Hardship withdrawals

Those experiencing a true financial crisis may also be eligible for a hardship withdrawal from their 401(k), 403(b) or 457(b) plan.

And, in 2020, retirement plan participants may also be eligible to withdraw up to $100,000 from their qualified retirement account without incurring the standard 10 percent early distribution penalty if they are younger than age 59-1/2. The distributions can be included in the employee’s income tax over three years and are not subject to a mandatory 20 percent federal withholding for “eligible rollover distributions.”

To qualify for the penalty-free distribution under the CARES Act, however, participants must have experienced adverse financial consequences resulting from a reduction in work hours; been laid off, quarantined, or furloughed; have a spouse or dependent who has been diagnosed with coronavirus; or been unable to work due to a lack of childcare because of the virus. (Related: What the stimulus package, CARES, does for you)

As the CARES Act currently stands, such leniency for retirement plan withdrawals is only available for 2020. After that, the traditional rules that have long governed hardship withdrawals are likely to resume.

As with loans, your plan sponsor is not required to offer hardship withdrawals and it is up to them to determine which conditions apply.

Under Internal Revenue Service guidelines, the employee, the employee’s spouse or the employee’s dependent must have an “immediate and heavy financial need” and the amount withdrawn must be “necessary to satisfy the financial need.”3

Acceptable reasons to take a hardship withdrawal may include paying medical expenses, buying a primary residence, paying tuition and fees, avoiding eviction or foreclosure from a primary residence, paying for burial or funeral expenses, or repairing a damaged primary residence. (Related: Handling a financial disaster)

You cannot take a hardship withdrawal from retirement savings if you have other resources to meet your need, according to the IRS.

For example, someone who owned a vacation home, but was having trouble making payments on their primary residence, would probably be expected under the terms for most 401(k) plans to sell the vacation home to meet cash flow problems rather than take a hardship withdrawal.

Most 401(k) plans also provide that hardship withdrawals are not available if you could obtain a commercial loan to solve your problem or if you have not exhausted your options for taking out a loan from your plan.

If you take a hardship withdrawal, you will not be allowed to contribute to your plan again for at least six months. The distribution from the savings plan will be taxed as income and assessed a 10 percent penalty unless you are at least 59-1/2 years old. (Again, unless your withdrawal qualifies for the penalty waiver for 2020, under the CARES Act.)

Unlike a 401(k) loan, a 401(k) hardship withdrawal does not have to be repaid — in fact, you cannot repay it even if you want to. The CARES Act permits Coronavirus-related hardship withdrawals to be repaid into an IRA or qualifying retirement plan within three years to avoid taxation. Any taxes already paid, because the withdrawal is taxable over three years, may be refunded to the extent the amount taxed in prior years was repaid. An amended tax return may be required.

At most, you could try to make up for the withdrawal by increasing your 401(k) contributions for retirement later on when your financial situation improves.

For example, if you were contributing 5 percent of your pretax earnings to your 401(k) before you took the hardship withdrawal, once you’re allowed to contribute to your plan again and have the resources to do so, you could increase your contribution rate to 10 percent or more.

401(k) plans should not be used as a piggy bank. But for those experiencing a financial emergency, a loan or withdrawal from savings does not necessarily doom their financial future, either.

Just be sure you understand the consequences and consider all alternatives first.

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1 MoneyMagnify, “Survey: Most Americans Have Raided Their Retirement Savings,” Aug. 20, 2019.

2 Employee Benefit Research Institute Issue Brief No. 458, “401(k) Plan Asset Allocation, Account Balances, and Loan Activity in 2016,” Sept. 10, 2018.
3 Internal Revenue Service, “Retirement Plans FAQs Regarding Hardship Distributions,” IRS.gov, last updated February 19, 2016

The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.