Saving for retirement 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, especially when present needs are pressing.
In 2020, 9 percent of non-retired adults borrowed or withdrew funds from a retirement account, and 14 percent of non-retired adults who experienced a layoff tapped this source, according to the Federal Reserve. Non-retirees with retirement account balances under $50,000 were more likely to do so than those with higher balances.1
Should you find yourself considering this option, 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 the 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. Employer plan sponsors must not allow plan participants to borrow more than:
- The greater of $10,000 or 50 percent of their vested account balance; or
- $50,000, whichever is less.
In other words, if your vested 401(k) balance is $60,000, you may potentially borrow up to $30,000. If your vested balance is $120,000, you may be able to borrow up to $50,000.
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 rules related to both retirement plan loans and outright withdrawals. For participants in eligible retirement plans, the legislation raised the limit on loans from 401(k)s (and other eligible retirement plans) to the lesser of $100,000 or the vested account balance. The Consolidated Appropriations Act, 2021, extended this temporary increase in borrowing limits through mid-2021.
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) and 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. However, you could be taxed on the outstanding balance and assessed an additional tax penalty for early withdrawals if you are not older than 59 ½ years. There could also be fees, depending on the terms of your plan.
401(k) loans 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 (IRAs). Any distribution from an IRA before age 59-1/2 is subject to ordinary income taxes, plus a 10 percent early withdrawal penalty.
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 2018, according to the Employee Benefit Research Institute The average unpaid balance was $8,162 and the median loan balance outstanding was $4,486. Most borrowers tap less than 30 percent of their account balance.1
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 many 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 Shoup, 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.
With all the costs and consequences, you may want to limit borrowing to a true emergency. 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 may be 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?)
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, at least in the short run. 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 as long as you repay it.
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.
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.
At the very least, make sure to repay your loan. Why? Failure to repay your loan will be considered a distribution on the unpaid balance and you will owe taxes (at your marginal income tax rate). If you are younger than age 59-1/2, you will also owe a 10 percent early withdrawal penalty 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 the 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.
Those experiencing a true financial crisis may be eligible for a hardship withdrawal from their 401(k) plan.
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.”2
Generally, a hardship withdrawal may include paying medical expenses, avoiding eviction or foreclosure from a primary residence, paying for burial or funeral expenses, or repairing a damaged primary residence, or to pay education tuition, room and board, and fees for the next 12 months for you, your spouse, and other dependents. (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, might be expected under the terms of most 401(k) plans to sell the vacation home to meet cash flow problems rather than take a hardship withdrawal.
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.
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 (unless you took a coronavirus-related hardship withdrawal under the CARES Act, in which case you have three years to repay the money and avoid taxation).
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 (subject to contribution limits).
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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This article was originally published in August 2016. It has been updated.