February 21, 2024
Written by Jerry Brown
Certified Financial Education Instructor®
Certified Financial Education Instructor®
Jerry Brown, CFEI®, is a freelance personal finance writer with over three years of experience. He's written articles for several major publishers, including Newsweek, Investopedia, and Bankrate.
Need cash and you're considering borrowing from your 401(k)? Ideally, you'll want to do this without paying penalties and fees. A 401(k) loan is a potential solution – you don't even need to agree to a credit check to get approved. However, there are some possible drawbacks you should consider before applying.
Here's how taking out a 401(k) loan works, including the benefits and drawbacks and alternative financing options to consider.
Some plan administrators allow you to request a loan from your 401(k) online or by contacting a plan representative. If you're married, some plans might require you to get your spouse's approval if you request a loan over $5,000. Once the administrator approves your loan, you can receive the funds via check or direct deposit.
The repayment term is generally five years. Depending on your plan, you can choose to have payments, including interest, automatically deducted from your paychecks. However, if you're using the funds to purchase a home as your primary residence, the repayment term could last up to 30 years.1,2
You can sometimes repay the loan early without worrying about a prepayment penalty, but check with your plan administrator to make sure.3
Interest rates will vary depending on your plan. That said, the interest rate is normally based on economic conditions and may be lower than other types of financial products, depending on your credit profile.
The IRS limits the amount a person can borrow from their 401(k) to $50,000 or 50% of the vested balance (the portion you own), whichever is lower.
For example, if your vested balance is $35,000, you can borrow up to $17,500 if your plan allows it.
However, in some cases, your plan might allow you to borrow up to $10,000 even if the amount you own in your 401(k) is below $10,000.2
Now that you know how to borrow money from your 401(k), you may wonder whether it's right for you.
Although a 401(k) loan can provide you with the cash you need, it can reduce your retirement portfolio's growth. Below are some pros and cons to consider:
No credit check requirement: Generally speaking, a 401(k) loan doesn't require a credit check, meaning you won't temporarily lower your credit score.
Missed payments do not impact your credit score: Although missed payments can lead to other harmful consequences, they won't affect your credit profile since employers don't report late payments to the main credit bureaus – Equifax, Experian, and TransUnion.
You're repaying yourself: When you repay a 401(k) loan, you're repaying yourself back with interest instead of to a lender.
You may have to repay the loan in full if you leave your job: Some plan administrators require you to repay the total amount you borrowed when you leave your job.
You could miss out on investment gains: When you borrow from your 401(k), the money is no longer invested in stocks and other assets. As a result, your portfolio could miss out on potential growth.
Missing payments could lead to tax penalties: Not repaying your 401(k) loan could lead to a 10% tax penalty on the outstanding balance.4
Taking out a 401(k) loan comes with several potential risks. If you don't feel comfortable drawing from your retirement fund, consider these alternatives.
Personal loans: A personal loan is a flexible financing option you can use for just about any purpose, including consolidating debt.
Balance transfer credit card: You can use a balance transfer credit card to consolidate high-interest credit card debt.
Emergency loan: If you need money for an emergency situation, such as a flat tire or unexpected home repair, consider applying for an emergency loan.
Savings: If you don't need funds to cover an expense right away, save up by depositing a set amount each month into a savings account.
Family or friend loan: Ask a family member or friend to lend you money at a 0% or low interest rate. If they agree, repay it on time to keep your relationship intact.
Roth IRA withdrawal: Unlike a 401(k) loan, you can withdraw your contributions to a Roth IRA without paying a tax penalty. However, you might have to pay a penalty if you withdraw any earnings.5
There are several misconceptions about 401(k) loans. Below are some popular myths explained.
Negative consequences of leaving a job with an unpaid balance: Although your outstanding balance could be treated as a taxable distribution once you leave your job, you have until the tax filing deadline for the year you left to transfer the unpaid amount into an eligible retirement account to avoid penalties.6
Borrowing from your 401(k) is always a bad idea: Taking out a 401(k) loan comes with risk, but whether it's a bad idea depends on your financial situation. For example, using the funds to pay down high-interest credit card debt could improve your financial circumstances. Consider speaking to a financial advisor if you need help deciding if it's right for you.
You could also access your retirement funds via a 401(k) withdrawal. A withdrawal involves taking money from your retirement account without requesting a loan. Unlike a 401(k) loan, you don't have to repay a withdrawal.
Another key difference is that you'll generally incur tax penalties unless you qualify for an exception if you withdraw the money before retirement age at 59 and 1/2.7
Carefully consider the pros and cons of cashing out your 401(k).
A 401(k) loan can provide quick cash for emergencies. However, a downside is that borrowing money from it could slow the growth of your retirement portfolio. Plus, you may have to pay it back immediately if you lose your job or voluntarily leave. As a result, it's best to consider alternatives first, such as personal loans and emergency savings.
If you're interested in learning how other types of loans work, read our tips on how to manage debt.
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