A 401(k) loan is an opportunity for participants of a retirement plan to access a portion of their own funds, usually up to $50,000 or 50% of the assets, whichever is less.
People may borrow from their 401(k) for many reasons like funding the purchase of a house or paying for college tuition; however, most plans don’t require participants to declare why they are taking out these loans.
We look at what a 401(k) loan is, how to get one, and the benefits and drawbacks of these types of loans.
What is a 401(k) loan?
A 401(k) loan is a loan that is taken out against the balance of a 401(k) retirement savings account. The loan is typically used to cover unexpected expenses or consolidate debt and must be repaid within five years with interest.
Taking out a 401(k) loan can be costly, as it reduces the funds available for retirement and may incur penalties if the loan is not repaid on time.
Strictly speaking, 401(k) loans aren’t seen as real loans in a conventional way, as they don’t include a lender or require a good credit history to qualify.
The participant repays any interest charged on the loan balance to his or her own 401(k) account so it can be considered as transferring money from one pocket to another rather than paying interest expense on a bank or consumer loan.
A 401(k) loan can be used to finance large purchases and expenses such as:
- Home renovations and repairs
- College tuition fees
- Medical bills and insurance premiums
- Vehicle purchases (including cars, motorcycles, RVs, etc.)
- Home improvements (such as new floors or siding)
What is a 401k?
A 401(k) is an employer-sponsored savings plan that allows individuals to set aside pre-tax or after-tax dollars from their paychecks for retirement.
These loans can be a good option under certain circumstances, such as when high-interest title loans, credit card cash advances, or personal loans would cost more than double the interest rate of a 401(k) loan.
Additionally, the designers of the 401(k) plan have included the ability for hardship distributions which allow you to take withdrawals from the account in cases of emergency medical expenses or mortgage payments.
The Benefits of Taking Out a 401(k) Loan
Here are a few benefits of 401(k) loans:
1. Access to funds without having to apply for a regular loan
Taking out a 401(k) loan is normally a fast and easy process that doesn’t require a complication application process or any credit checks. It does not lead to a hard credit inquiry or affect your credit score.
Unlike applying for a regular loan, with 401(k) loans you may not be able to get as much money as quickly or at the lowest possible interest rate.
Additionally, taking out a 401(k) loan could jeopardize your retirement funds if you are unable to repay it in time.
2. Interest-free loan for the duration of the plan
Taking out a 401(k) loan can benefit the plan holder by providing them with additional funds to invest in their retirement.
This allows them to potentially earn higher returns on their investments, which could help them reach their retirement goals faster.
By taking out a 401(k) loan, plan holders can access the money they may not otherwise have access to.
This can be used to make contributions or take advantage of investment opportunities that may not have been available without the loan.
Additionally, since the interest rate is typically lower than other types of loans, taking out a 401(k) loan can also save money on interest expenses over time.
3. Access to larger sums than with a traditional IRA
Taking out a 401(k) loan and using a traditional IRA both allow you to access your retirement funds. With both options, the money is safe from creditors and you can use the funds for any purpose.
One major difference between taking out a 401(k) loan and using a traditional IRA is that taking out a 401(k) loan may affect your bankruptcy protection since it’s considered an “outright withdrawal” of your assets.
Additionally, when taking out a 401(k) loan there may be fees associated with it such as origination fees or administrative fees that aren’t present in traditional IRAs.
4. Tax advantage – 401(k) contributions are tax-deductible
Contributions to a 401(k) are tax-deductible, which means that taxpayers can reduce their taxable income by the amount of money they contribute.
This reduces the overall tax burden for individuals who make 401(k) contributions and allows them to save more for retirement with less of an impact on their current income.
The Drawbacks of 401(k) Loans
401(k) loans are becoming increasingly popular, as they offer a way to borrow money without having to pay taxes or penalties.
However, there are some important things to know before taking out a 401(k) loan.
The first thing to understand is that a 401(k) loan is not a true loan. Rather, it is a withdrawal from your 401(k) account.
This means that the money you borrow will no longer be invested in your retirement account and will not grow tax-deferred.
Additionally, if you leave your job (for any reason), you will typically have to repay the entire loan within 60 days or it will be considered a distribution subject to income taxes and possibly a 10% early withdrawal penalty.
Another important thing to consider is the interest rate on 401(k) loans. The interest rate is generally set at prime + 1%, which means it can be quite high.
How To Get a 401(k) Loan
E.g., if the prime is 3%, then your interest rate on the loan would be 4%. This can add up quickly, so it’s important to make sure you can afford the payments.
To apply for a 401(k) loan, simply contact your plan administrator and request an application. Once you’ve completed the application, returned it to the administrator along with any required documentation (such as proof of employment).
The administrator will then review your application and determine whether or not you’re eligible for the loan.
Alternatives to taking out a 401(k) loan
There are a few alternatives to taking out a 401(k) loan that you should consider before deciding on this option.
Another alternative is to use a credit card for expenses related to your 401(k).
This can be a good option if you have good credit and can pay off the balance quickly. Finally, you could consider withdrawing money from your 401(k) early, though this typically comes with penalties and taxes.
Taking out a 401(k) loan can be a great way to access needed funds without having to take on more debt.
It’s important to remember, however, that the money lent from your retirement account isn’t free—you need to pay it back with interest.
That said, if you know how the process works and understand all the associated costs and risks involved in taking out a 401(k) loan, then this could be an effective strategy for getting emergency cash without having to rely on traditional loans or credit cards.