An Introduction to 401(k) Loans

These loans are not true loans by definition because they do not involve either a lender or a credit history check. They are better referred to as the ability to withdraw a portion of your own retirement plan funds tax-free, often up to $50,000 or 50% of the assets. Here we will take a closer look at how exactly they work and what are some benefits and drawbacks of them.  

A loan on 401(k) is a type of loan that allows you to borrow money from your 401(k) account. These funds are then later on repaid with interest, but this still can be a great way to get some extra cash if you need it.  

Before you actually consider applying, there are a couple of things to look into first. You’ll need to make sure that your 401(k) plan allows for loans. Not all plans do, so it’s important to check with your plan administrator beforehand. Second, look into the terms of the loan and understand them fully. Typically, with 401(k) lending, they must be repaid within a five-year period, though some plans may allow longer terms.   

Last but not least, keep in mind that borrowing from your 401(k) will lower the amount of money available for retirement savings. Before moving forward with this loan, be sure you’re comfortable with the risks involved.  

What Are 401(k) Loans?

A 401(k) loan is a loan that is taken out against your 401(k)-retirement account. Although interest rates on them are usually lower than rates on other types of loans, they will still accumulate while you are paying them back. The money you took out from this loan can be used for a variety of purposes but it’s frequently used for short-term needs, such as a down payment on a house or to pay off high-interest debt.  

Nonetheless, there are some risks associated with these loans. If you for example leave your job, you’ll need to repay the loan within 60 days or it will be seen as a withdrawal from your account. This withdrawal will also trigger taxes and some other penalties that need to be paid as well. In addition to this, defaulting on this loan will make money you owe considered a distribution from your account, so besides taxes, many other fees will pile up.  

Because of these factors, it’s crucial to consider all your options before taking out a 401(k) loan. Whatever you decide, be sure you are aware of the advantages and risks.  

Benefits and Drawbacks of a 401(k) Loan

Loan 401(k) can seem like a great option if you need money short-term and just don’t want to take out a more traditional loan. Let’s take a better look at both the positive and negative sides associated with these loans so you can make an informed decision in the end.  

Benefits  

• Can help you to cover unexpected expenses or make a large purchase that you would not be able to afford otherwise.   

• There is a quick and easy application process so once you apply for a 401k loan you can have funds in your hands within just a few days.  

• You can take these loans to consolidate debt  

• Can help in building your credit history and improve your credit score. If you make your payments on time, it will show that you are a responsible borrower, giving you more loan possibilities in the future.  

• The interest you pay on the loan goes back into your account. This will of course boost your savings. Additionally, you won’t have to pay taxes on the loan amount because it isn’t regarded as taxable income.  

Drawbacks  

There are also some drawbacks to a 401k retirement loan:  

• You will have to pay interest on the loan. This can add up over time and end up costing quite a bit.   

• If you default on the loan, there could be legal actions taken against you.  

• It can damage your credit score if you keep missing your payments. This will make it harder to borrow money in the future.  

• If you leave your job, you will typically have to repay the loan within 60 days. If you can’t repay it, the amount will be considered taxable income. There is also an early withdrawal penalty to be paid.  

What Happens to Your 401(k) Loan When You Leave a Job?

As we already discussed, if you decide to leave your job while the loan term is still ongoing, you will need to repay the outstanding amount within 60 days. If you don’t end up paying this amount in this time frame, there will be many fees and penalties as well as taxes.  

That is why you should never jump the gun and take out a loan if you don’t fully understand everything that comes with it. 401k loan terms are not really that long, so a good option can also be staying at your job until it’s finished.  

Are 401(k) Loans a Good Idea?

These loans are a good way to secure much-needed financial assistance in a tight spot. On the other hand, there are still some potential risks involved with 401k borrowing in advance from your retirement savings.  

If you first take some time to budget everything in, so you are sure you can afford the monthly payments over the years, this loan can be a good option. Even though it does have lower interest rates, you still need to consider the impact on your retirement savings. In a sense, when you choose a 401(k)-loan option you are borrowing from your future self. Before moving forward, be sure you’re comfortable with this impact on your retirement savings.  

Alternatives to 401(k) Loans

If you need money, there are a few options outside 401(k) loans to take into account.  

One option is to take out a personal loan from a bank or credit union. You can also take this loan from a friend or family member so it will surely offer you even more flexible repayment terms.  

Another option is to withdraw money from your IRA account. However, you will have to pay taxes and penalties here if you are younger than 59 1/2 years old. A third option is to get a home equity loan if you have some equity in your house.   

These are not the only alternatives available but in general, the right choice will depend on your personal situation as well as your financial needs.  

Final Thoughts

In today’s world, borrowers have access to a wide variety of loans, so picking the best one can be challenging. Taking any loan can be risky if you are not familiar with the terms and conditions before signing up so do your research beforehand. Whatever option you choose don’t forget to shop around and compare interest rates, fees, and repayment terms. If this all gets too confusing for you, we suggest you hire an experienced financial advisor to help you figure out can you get a 401k loan and how to do so.