Should You Borrow from Your 401(k)?

When financial needs arise, your 401(k) might seem like a tempting source of funds. After all, it’s your money, and borrowing from yourself might appear better than taking out a traditional loan. However, before tapping into your retirement savings, it’s crucial to understand both the benefits and potential drawbacks of 401(k) loans. 

How 401(k) Loans Work 

A 401(k) loan allows you to borrow up to 50% of your vested account balance or $50,000, whichever is less. These loans typically must be repaid within five years, with payments made through automatic payroll deductions. The interest rate is usually set at prime rate plus 1%, and importantly, you pay the interest back to your own account. 

Potential Advantages 

Lower Interest Rates 

Compared to credit cards or personal loans, 401(k) loans often offer more favorable interest rates. Since you’re borrowing from yourself, the interest you pay goes back into your account rather than to a bank. 

No Credit Check Required 

Unlike traditional loans, 401(k) loans don’t require a credit check. This can be particularly beneficial if you have less-than-perfect credit or need funds quickly. 

Convenient Application Process 

The application process is typically straightforward, with fewer requirements than traditional loans. Funds are usually available quickly, and there’s no need to provide collateral. 

Significant Drawbacks 

Missing Out on Investment Growth 

Perhaps the biggest downside is the opportunity cost. While your money is out of your account, you’re missing potential market gains and compound interest growth. This can significantly impact your long-term retirement savings. 

Tax Complications 

If you leave your job (voluntarily or involuntarily) with an outstanding 401(k) loan, the remaining balance typically becomes due within 60-90 days. If you can’t repay it, the loan is treated as a distribution, subject to income taxes and potentially a 10% early withdrawal penalty if you’re under 59½. 

Double Taxation on Interest 

While loan payments are made with after-tax dollars, the interest you pay back into your account will be taxed again when you withdraw it in retirement, resulting in double taxation. 

Reduced Retirement Savings 

Many people reduce or stop their regular 401(k) contributions while repaying a loan, further impacting their retirement savings. Additionally, some plans don’t allow you to make new contributions until the loan is repaid. 

Alternative Options to Consider 

Before taking a 401(k) loan, consider these alternatives: 

• Home equity line of credit (HELOC) 

• Personal loans from banks or credit unions 

• Zero-interest credit card balance transfers 

• Emergency fund savings 

• Budgeting and expense reduction 

When a 401(k) Loan Might Make Sense 

There are situations where a 401(k) loan could be appropriate: 

• To avoid high-interest debt consolidation 

• For a short-term bridge loan when you’re certain of repayment 

• In true emergencies when other options are exhausted 

• For a down payment on a primary residence (these loans may qualify for a longer repayment period) 

Final Considerations 

Before taking a 401(k) loan, ask yourself: 

• Do I have a stable job and income? 

• Can I afford the loan payments without reducing regular 401(k) contributions? 

• Have I explored all other borrowing options? 

• Do I understand the impact on my long-term retirement savings? 

• What would happen if I lost my job while having an outstanding loan? 

Every investor’s situation is unique, and you should consider your investment goals, risk tolerance, and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation.  

The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete; it is not a statement of all available data necessary for making an investment decision and does not constitute a recommendation.  

Any opinions are those of Tyler Russell and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification.