401(k) Loans Wisely: Benefits, Risks, and Rules
At times, you may encounter situations where you need to take an urgent loan. Since most instant loans have high-interest rates, a 401(k) loan might be a decent alternative for such circumstances. But don't rush; weigh all the pros and cons, as you potentially risk losing savings from your account.
Borrowing from a 401(k) means using funds that go into your savings account through contributions to a personal pension fund. You can borrow or withdraw these funds permanently, but in the latter case, you'll have to pay additional fees.
Based on Fidelity data, as of Q2 2023, the average balance of a 401(k) account is $112,400 per U.S. citizen. The rate of outstanding loans on this account type increased to 17.1%, compared to 16.6% in the first quarter. During the same period, the number of retirees with six-figure balances also increased. This indicates a high demand for the 401(k) retirement program in the U.S.
Today, Rates experts will help you determine whether it's worth using a loan against 401(k) or if you should make use of other models for quickly obtaining finances to cover urgent needs.
401(K) Loans as a Smart Financial Choice
Let's deal with the obvious right off the bat: Can I borrow from my 401(k)? Yes, you can get funds for current essential expenses this way. Unlike a bank or consumer loan, a loan from a 401(k) does not impact your credit history, impose significant restrictions on you (except for mortgage expenses), or establish excessively high fees. The program allows you to cover urgent financial needs and even increase your account balance by saving on the fees you repay for the loan. Here are the other benefits you receive:
Get Funds Quickly
Unlike traditional loans, here, your employer will quickly review your application and provide the requested amount if your loan balance allows it. The amount may be modest, but it can help you in a critical moment.
Increase Your Account Balance
Even if you are charged interest for taking a loan from a 401(k), you shouldn't worry. Every cent you pay over the loan repayment amount will go into your current balance and increase it.
Withdraw a Portion of the Funds Early
In addition to a loan, which does not affect your credit history, you can withdraw money permanently within a specified limit. In this case, you'll have to pay a fee, which will ultimately go into your account, before you can borrow from a 401(k) again.
What Risks Come With the Use of 401(K) Loans?
Borrowing a personal loan isn't always a good idea, especially if you have other savings that don't impact your credit history or access to credit that can cover urgent issues. Remember, this is not an extra credit card for everyday purchases or gifts, and you should only resort to it in emergencies.
Potential Penalties for Using the Funds
Understanding how 401(k) loans work, you should realize that they aren’t meant for use if you’re under the age of 59.5. Thus, if you fail to repay the loan completely during the grace period, including interest rates and fees, you will also have to pay a 10% penalty.
Reduced Retirement Savings
Depending on market rates, your savings account can generate an annual revenue of 5-8%. This means that the longer you will repay your loan, the more money you will lose. When it comes to tens of thousands of dollars, even one week missed is a heavy financial blow.
Risk of Job Loss
When you leave a job, whether it was your decision or not, your 401 (k) may become due right after that moment. Failing to pay it right away will lead to additional fees and penalties.
Terms of 401(k) Loans You Should Know
Most terms and conditions of the loan will depend on the company you work with. For example, if you often change jobs, even if you have an outstanding balance on a loan from a 401(k), your employer will likely demand a prompt repayment. The repayment period can vary from a few days to several months. The available fund might also not be enough to cover your urgent needs since loan amounts are limited. To the question "How much can I borrow from my 401(k)?" we can answer that it's no more than $50,000 or up to 50% of the balance, depending on whichever is less.
Effective alternatives to loans from a 401(k) can include zero-interest period bank credit programs, HSA savings for qualified medical expenses, using reserve accounts (possibly family ones), and personal loans. You can also transition to an IRA, where withdrawals are not taxed, regardless of the amount and term of the loan.
401(k) loans are a decent option in genuinely difficult situations when you don't have access to other sources of funding. This way, you can get extra cash quickly, regardless of your financial and credit history. And even in the case you fail to repay the loan, your credit history won't be affected.
However, the exact amount and repayment period will depend on your employer and might not satisfy your needs, unlike usual bank loans. Besides, there are certain risks if you fail to repay the loan on time, so you should definitely use it only if you have no other choice.
What are the tax implications of 401(k) loans?
You don't have to pay any taxes when you use a 401(k) loan unless you fail to pay on time. If so, you’ll have to pay an income tax of 10-22% depending on the amount withdrawn, and a 10% penalty if you're under the age of 59.5.
How can I apply for a 401(k) loan?
When taking a loan from a 401(k), you need to contact your employer and discuss the loan terms and repayment. Then, fill out the paperwork and receive the funds. You must adhere to repayment deadlines and regularly accumulate funds in the retirement account to avoid negative consequences.
Examples of how to use 401(k) loans wisely?
As for good examples, we can consider the case of purchasing real estate using funds from a retirement account. Considering that you will repay the loan, adding a certain amount to the balance, you will acquire an asset that will appreciate over time and sell it profitably later.