If you have a 401(k) plan at work and need some cash, you might be tempted to borrow or withdraw money from it. But keep in mind that the purpose of a 401(k) is to save for retirement. Take money out of it now, and you’ll risk running out of money during retirement. You may also face stiff tax consequences and penalties for withdrawing money before age 59½. Still, if you’re facing a financial emergency — for instance, your child’s college tuition is almost due and your 401(k) is your only source of available funds — borrowing or withdrawing money from your 401(k) may be your only option.
Plan loans
To find out if you’re allowed to borrow from your 401(k) plan and under what circumstances, check with your plan’s administrator or read your summary plan description. Some employers allow 401(k) loans only in cases of financial hardship, but you may be able to borrow money to buy a car, to improve your home, or to use for other purposes.
Generally, obtaining a 401(k) loan is easy — there’s little paperwork, and there’s no credit check. The fees are limited, too — you may be charged a small processing fee, but that’s generally it.
How much can you borrow?
No matter how much you have in your 401(k) plan, you probably won’t be able to borrow the entire sum. Generally, you can’t borrow more than $50,000 or one-half of your vested plan benefits, whichever is less. (An exception applies if your account value is less than $20,000; in this case, you may be able to borrow up to $10,000, even if this is your entire balance.)
What are the requirements for repaying the loan?
Typically, you have to repay money you’ve borrowed from your 401(k) within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have a much longer period of time to repay the loan.
Make sure you follow to the letter the repayment requirements for your loan. If you don’t repay the loan as required, the money you borrowed will be considered a taxable distribution. If you’re under age 59½, you’ll owe a 10% federal penalty tax, as well as regular income tax on the outstanding loan balance (other than the portion that represents any after-tax or Roth contributions you’ve made to the plan).
What are the advantages of borrowing money from your 401(k)?
- You won’t pay taxes and penalties on the amount you borrow, as long as the loan is repaid on time
- Interest rates on 401(k) plan loans must be consistent with the rates charged by banks and other commercial institutions for similar loans
- In most cases, the interest you pay on borrowed funds is credited to your own plan account; you pay interest to yourself, not to a bank or other lender
What are the disadvantages of borrowing money from your 401(k)?
- If you don’t repay your plan loan when required, it will generally be treated as a taxable distribution.
- If you leave your employer’s service (whether voluntarily or not) and still have an outstanding balance on a plan loan, the outstanding amount of the loan will be considered a distribution. You’ll usually be required to repay the amount in full (or roll over the amount to another 401(k) plan or IRA) by the tax filing deadline (including extensions) of the year following the year the amount is determined to be a distribution (i.e., the year you leave your employer). Otherwise, the outstanding balance will be treated as a taxable distribution, and you’ll owe a 10% penalty tax (if you’re under age 59½) in addition to regular income taxes.
- Loan interest is generally not tax deductible (unless the loan is secured by your principal residence).
- In most cases, the amount you borrow is removed from your 401(k) plan account, and your loan payments are credited back to your account. You’ll lose out on any tax-deferred (or, in the case of Roth accounts, potentially tax-free) investment earnings that may have accrued on the borrowed funds had they remained in your 401(k) plan account.
- Loan payments are made with after-tax dollars.