Preparing for retirement is very important, but what happens if you need to access your funds early in a 401(k)? What options are available, and should you take them?

What Is a 401(k) Loan?

A 401(k) loan is a loan against your retirement account. You borrow the money for a set period and make regular payments on it until the amount borrowed, plus interest, is paid in full.

Not all 401(k) plans allow participants to take out a loan against their 401(k), but those that do, such as an individual 401(k) and a self-directed 401(k), typically require payment within five years–loans for the purchase of a primary residence may have longer terms. Annual loan maximums are typically capped at the lesser of 50% of your vested interest or $50,000.

For example, if you have $30,000 in your retirement plan, you can only borrow up to $15,000.

However, you can take more than one loan out at a time, but the total balance of all loans can be, at most, the maximum amount allowed by your plan. In this case, if you have $150,000 in your account, your maximum loan amount would be $50,000.  If you already took out a $30,000 loan against your account, the maximum amount of a second loan would be $20,000.

Though the IRS sets rules that govern all qualified retirement account loans, including 401(k) loans, maximum terms and loan amounts, and other rules and requirements can vary by plan.

401(k) Qualifications and Penalties

If you’re considering taking a 401(k) loan, take time to understand the qualifications and penalties associated with this type of financing.

401(k) loan qualifications

The rules regarding 401(k) loans vary by plan and employer, but generally, there are few qualifications. That makes it an accessible financing option for borrowers who don’t meet traditional financial institutions’ credit or income requirements. However, there are a few things to keep in mind.

If you’re married, your plan may require your spouse’s consent before you can take out the loan. You also can’t exceed the number of loans allowed by your plan. So, if you already took out a loan against your 401(k), you may not qualify for a second or third one, depending on your plan’s policies.

401(k) loan penalties

Taking a loan out against your 401(k) is not without risk, and if you don’t comply with the rules and regulations set by your employer and the IRS, you may face penalties. According to the IRS, penalties typically come into play if:

• Your loan amount is higher than the maximum dollar allowed.
• You fail to make the required payments, pushing your loan into default.
• Your loan repayment schedule doesn’t meet the required payment or time limits.

In these cases, your loan will be considered a “deemed distribution.” The penalty for a deemed distribution can have costly tax implications. Primarily, your loan will be considered taxable income, and you may also be required to pay a 10% early distribution tax.

Pros and Cons of a 401(k) Loan

Not sure if a 401(k) loan is the right financing option for you?  Factor these pros and cons into your decision:

Pros of a 401(k) loan

Easier to obtain

A 401(k) loan has fewer qualifications, and unlike other types of borrowing options, you’ll likely be able to skip a credit check and avoid other common loan qualifications. A quicker application process can also work to speed up the borrowing process.

Lower interest rates

In many cases, a 401(k) loan has lower interest rates than those associated with a bank or credit union loan.  It almost always will have a lower interest rate than those attached to a credit card unless you qualify for a 0% APR credit card promotion.

Avoid taxes or penalties

If you simply withdraw from your 401(k), you’ll need to pay income tax on the amount withdrawn, and if you aren’t 59 ½ or older, you’ll likely be penalized for an early withdrawal. A 401(k) loan is usually tax and penalty-free if you meet your repayment requirements.

Cons of a 401(k) loan

Loan maximum may be too low

A 401(k) loan can’t exceed $50,000 or 50% of your vested interest, whichever is less.  Depending on the reason you’re borrowing, this may not be enough to cover your needs.

Short repayment period

In most cases, a 401(k) loan must be repaid within 5 years or less. That can make monthly payments high, depending on how much you’re borrowing.  Always balance your borrowing needs with your budget to ensure you can repay your loan on time.

Potential tax implications

If you don’t follow your repayment schedule, your loan may be considered a withdrawal and taxed. In that case, you may be on the hook for an income tax on the loan and a 10% early withdrawal penalty.

Tied to your employer

Since your 401(k) is tied to your employer, a loan from your account is, too. So if you leave your company, on your own accord or otherwise, your loan balance may become due sooner than you anticipated.

Alternative Ideas to a 401(k) Loan

A 401(k) loan may be easier to obtain, but it can jeopardize your retirement goals. Before you get a 401(k), weigh the pros and cons of these options.

Get a traditional loan.

If you have a good credit score and are likely to meet other common requirements for a traditional bank or credit union loan, consider going that route. Personal loans are usually available as secured or unsecured.

A secured loan requires collateral, like a vehicle or home, but normally has lower interest rates.  An unsecured loan doesn’t require collateral, but you will likely have a higher interest rate.

Leverage your home equity.

If you own your home and have 15% to 20% equity in it, then you may be able to take out a home equity loan or home equity line of credit to help you manage your financial needs. Both options are likely to have lower interest rates than a traditional loan.

Use a 0% APR credit card.

If you qualify for a 0% APR credit card and your limit is enough to cover your needs, you may want to consider this option. However, remember that 0% financing options typically come with an end date, and you’ll need to pay the card off before the financing promotion ends. If you don’t, you’ll be required to pay interest on the remaining balance or the total purchase, depending on your credit card terms.

Borrow from family or friends.

If a family member or friend is in a position to lend you money, this option can help you avoid credit checks, high interest rates, and other challenges commonly associated with borrowing.

However, a loan can quickly cause tension or erode relationships. Always approach this repayment commitment the same way you would a loan from a traditional lender, creating a repayment schedule — with or without interest — and thoroughly discussing the loan terms.

Takeaways

A 401(k) loan may be a convenient option to help you through financial struggles, but it may not always be the best option. In some cases, using a self-directed IRA to loan money or acquiring a traditional loan may be more advisable. Be sure to speak to a financial representative before taking a loan from your 401(k) to make sure you are making the right decision.