Pros and cons of borrowing from your 401(k) – Forbes Advisor

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If you find yourself in a financial crisis, you might consider borrowing from your 401(k). The problem is that while a 401(k) loan may be faster and cheaper than other types of credit, you may also be jeopardizing your retirement goals.

Before taking out a 401(k) loan, it’s important to know the pros and cons, as well as possible alternatives, so you can make an informed borrowing decision.

Advantages and disadvantages of 401(k) loans

Benefits of borrowing from your 401(k)

When cash is tight and options are scarce, a 401(k) loan can help you fill a financial gap quickly, and with notable benefits. Not only can you borrow from yourself and repay yourself with interest.

You can continue to contribute to your 401(k) while you pay off the loan, an option that may not be available if you are making a hardship withdrawal.

1. No lengthy loan applications

Since you’re borrowing money from yourself, there’s no grueling loan application to take out a loan from your 401(k).

Although you need to provide basic information to your plan administrator, it’s not as much as you would need to give to a bank. The warning ? If you are married, some 401(k) plans require spousal approval for loan applications.

2. Avoid taxes and penalties

While hardship withdrawals from a 401(k) are taxed as ordinary income and come with a 10% early withdrawal penalty, loans do not suffer the same fate. You’ll generally avoid taxes and penalties if you borrow from your 401(k).

An exception is if you default on your loan. In this case, you will pay the penalty and taxes if you are under 59.5 years old.

3. Lower borrowing costs

You’ll still pay interest on a loan from your 401(k), but you could save compared to interest rates from traditional lenders. A bonus? The interest you pay goes into your account instead of your bank’s vaults.

4. No credit impact

Borrowing from your 401(k) is rarely accompanied by an investigation of your credit report, and loans are not reported to the three major credit bureaus.

If you’ve found it difficult to qualify for traditional loans because of your credit score, a loan without a credit check from your 401(k) could be a saving grace.

5. Take advantage of automatic deductions

Just as your 401(k) contributions are automatically deducted from your salary, so are your loan repayments. Putting your payments on autopilot keeps your loan current and more of your money working in the market.

Disadvantages of borrowing from your 401(k)

While it’s fairly simple to borrow from your 401(k), that doesn’t mean it’s a hassle-free process. When available, loans from a 401(k) have limits, rules, and a few quirks.

1. Your plan must allow loans

Unfortunately, not all 401(k) plans allow loans. A brief conversation with your benefits department or plan administrator can explain your plan’s loan policy.

2. Loans have limits

Although you can borrow from your 401(k), the IRS sets loan limits. Currently, you can borrow up to 50% of your acquired account balance of $50,000, whichever is less. Some plans offer exceptions if you have a vested balance of less than $10,000, but that’s not the norm.

3. No bankruptcy protection

Of all the types of debt that are discharged during bankruptcy, 401(k) loans are not one of them. If you file for bankruptcy, you’ll still have to pay off your 401(k) loan or face taxes and early withdrawal penalties.

4. Thinking of quitting your job? Be careful.

If you quit your job, voluntarily or not, your 401(k) loan will convert to an accelerated repayment schedule. Depending on your plan, you may need to repay the funds shortly after your departure date.

If your plan does not have a specific reimbursement plan for departing employees, you are bound by IRS rules. You’ll still need to pay off your loan balance in full by tax day the following year.

5. Opportunity costs can be high

Every time you take your money out of the market, you’re missing out on potential gains and the magic of compounding returns.

If you took out a one-year loan of $15,000 from your 401(k) on January 1, 2021, with an interest rate of 4.25%, you would repay $15,347. If you had instead left the money invested in an S&P 500 index fund, you would have $19,034 in your account. Taking out a loan means you would miss a return of more than $3,800.

Alternatives to borrowing from a 401(k)

Before you take out a loan from your 401(k) and potentially jeopardize your retirement savings, it’s important to explore other options.

Personal loans

A personal loan could help avoid the opportunity cost of withdrawing your money from the market. Although your application is more thorough, many online lenders like SoFi and Marcus of Goldman Sachs offer lightning-fast qualifications and show your interest rate without a firm credit application.

HELOC or home equity loan

If borrowing from you sounds good, you may be able to use the equity in your home instead of a 401(k) to access the money you need. A home equity line of credit (HELOC) or home equity loan can offer a competitive interest rate and more flexible loan terms.

If you qualify for a HELOC, you can also tap into those funds again once you’ve paid off the entire line — you won’t even have to requalify.

Debt advice

If you’re considering a 401(k) loan to pay off high-interest debt, consider debt counseling. Unlike predatory debt relief services with astronomical costs, credit counseling is a non-profit organization with low fees and potentially big impacts on your financial life.

These counselors will work with you and your creditors to establish repayment plans. They can also help you develop better money management habits to avoid future run-ins with crippling debt.

Should you borrow from your 401(k)?

While it rarely makes sense to plunder your retirement savings, there may be times when it makes sense to use your 401(k) for a much-needed loan.

When to choose a 401(k) loan

  • You can’t beat the price. If your 401(k) offers a 4% loan, but your bank can’t offer better than 8%, borrowing from your 401(k) might be a good consideration.
  • Speed ​​and convenience are a priority. With no credit checks and quick access to funds, these loans can help those with tight deadlines.
  • You have no other options. If other sources of money have run out, your 401(k) loan can be the lifesaver.

When to avoid a 401(k) loan

  • You have great credit. You can keep your retirement savings in the market while getting great rates on personal loans or a HELOC.
  • All signs point to a bull market. You will likely reinvest at a higher cost in rising markets as you repay your loan.

And whether you end up borrowing from your 401(k) or not, you now know what impact these loans can have on your finances, along with the alternatives.

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