Should I Borrow from My Retirement Savings?

If you need cash, whether your household lost income or you had a surprise expense, borrowing from your retirement account might seem like a good idea. After all, you intend to put the money back. But circumstances could arise while you have an outstanding loan that could jeopardize your nest egg. Before borrowing from your 401(k), it’s important to understand the risks. There are a few circumstances when taking a 401(k) loan could be beneficial, but in most cases it’s best to leave your retirement account alone.

How Do 401(k) Loans Work?

The first step is to check the details of your retirement plan or ask your plan sponsor if loans are allowed. About 90 percent of plan participants are eligible for a 401(k) loan. The law allows you to borrow up to $50,000 or half your retirement savings, whichever is less. The interest rate is usually about one or two points above the prime rate, regardless of your credit score. As long as you follow the repayment schedule, which can be a term of up to five years, the money isn’t taxed. There’s also no prepayment penalties if you end up being able to pay the loan off early.

How Do 401(k) Withdrawals Work?

401(k) withdrawals do not need to be paid back. However, if you’re younger than 59 ½, the amount will be taxed and incur a 10 percent penalty. For example, if you are in the 22 percent tax bracket and you withdraw $20,000 from your 401(k), you’ll only have $13,600 after paying taxes and the early withdrawal penalty. What’s more, you’ll be missing out on the opportunity for that money to grow. A $20,000 withdrawal at age 30 would have a future value of more than $476,000 by retirement age. The IRS does allow some exceptions, however. If you take a hardship distribution to cover certain pressing financial needs, you’ll still pay income tax on the withdrawal, but you won’t incur the 10 percent penalty. Some examples of when you might qualify for a hardship withdrawal include:

• You become totally and permanently disabled
• You have medical bills exceeding 10 percent of your adjusted gross income
• You are a military reservist called to active duty

You can also take a withdrawal of up to $10,000 to purchase your first home.

What Are the Risks of Borrowing from My 401(k)?

You May Not Be Able to Repay the Loan

If you can’t repay the loan on time, it becomes a withdrawal that is subject to income tax and a 10 percent penalty. Of course, there’s a risk of default with any loan, and paying taxes may be preferable to losing an asset, which could happen if you default on a secured loan.

You May End Up with Less Retirement Savings

If the interest you pay in offsets the lost potential growth of your investment and you keep making regular contributions to your 401(k) while the loan is outstanding, then there will be no impact on your future retirement savings. But if you can’t keep up with contributions while also paying back the loan, that’ll shrink your potential future savings.

Job Loss Could Devastate You Financially

Most plans require that if you lose your job or leave your job for any reason, you need to repay your outstanding 401(k) loan within 60 days. Depending on how much you borrowed, this may not be possible, especially if you are no longer earning income. That’s why 86 percent of plan participants who leave their companies with an outstanding loan end up in default. Luckily, the Tax Cuts and Jobs Act allows for borrowers to repay the loan to an IRA instead. If you chose that option, you’d have until your personal tax filing date for repayment, or up to six months after if you file an extension. Still, if you were counting on five years for repayment, coming up with enough cash to repay the loan by the deadline could be difficult.

What Are the Benefits of Borrowing from My 401(k)?

Interest Goes Towards Your Retirement Savings

If you borrow from a lender, you have to repay the lender with interest, which is how the lender profits. That can cut into your income and restrict the growth of your wealth. But if you borrow from your 401(k), the interest you pay goes towards your retirement savings. That interest will grow over time and become significant.

No Credit Check and No Credit Impact

If you have bad credit, it can be tough to find a loan. But if you borrow from your 401(k), there’s no credit check, and the interest rate is the same for all plan participants. It’s typically about one point higher than the prime rate, which historically has ranged from 3.25 percent to 21.5 percent. If you default on your 401(k) loan, your credit won’t take the hit, either. You’ll pay taxes and penalties, but it won’t be reported to the credit bureaus.

Fast and Convenient

401(k) loans are easy to qualify for and quick to obtain. You can usually receive the funds in one or two days if you complete the process online. Be advised that if you are married, your partner may be required to agree to the loan in writing. But you won’t need to provide any income information like you would with a lender.

4 Reasons to Borrow from Your 401(k)

In most cases, it’s not wise to raid your retirement savings, but there are some situations in which it makes sense to consider a 401(k) loan.

Making a Down Payment on a Home

One of the biggest barriers to homeownership is saving enough for a down payment. Taking a $10,000 loan from your 401(k) could be just the boost you need to buy a home, which would benefit you in the long run. Instead of paying rent, you’d be building equity. And you could even profit from your home due to appreciation. As long as you’re confident in being able to repay the loan, buying a house is a good reason to borrow. However, keep in mind that there are low down payment options available, something many consumers aren’t aware of. If you have enough to qualify for a mortgage without taking money from your 401(k), you might be better off keeping your nest egg where it is.

Getting a College Degree

If you feel like you can’t get ahead in your career without a college degree, borrowing from your 401(k) to pay for your tuition could make sense. College is an investment in future earnings — college graduates earn more than twice as much income over the course of their careers as people with a high school degree. You should try for financial aid and scholarships first, but your 401(k) could be an option for funding any leftover expense. The caveat is that you’ll need to pay the money back in five years. If that’s not possible, you should consider private student loans instead.

Paying Off High-Interest Debt

If you have debt with an APR that is much higher than the prime rate, it makes sense to borrow from your 401(k) to pay it off. For example, if the interest rate for your 401(k) loan is 4.5 percent and you have a $10,000 credit card balance with a 20 percent APR, you’ll save money on interest if you borrow from your 401(k) to pay off your debt. You could also borrow from your 401(k) if you are worried about default on a secured loan or have outstanding payday loans or other high-interest debt.

Dealing with Financial Hardship

If you’re unable to meet your basic needs due to income loss in your household or unexpected expenses, it makes sense to borrow from your 401(k) while you get back on your feet. That’s especially true if you have medical bills that would qualify you for a penalty-free hardship distribution. Even though you should still try to repay the loan, you won’t be penalized if you default — you’ll just need to pay income tax.

401(k) Loan Alternatives

A 401(k) loan isn’t the only option you have if you’re desperate for cash. Whether you have excellent credit or no credit history, alternative methods of borrowing are available. Consider one of the following.

Personal Loan

Personal loans come in amounts from a few hundred dollars to $50,000 or more. You receive them in a lump sum and repay them with fixed monthly payments over a period of two to five years. For people with excellent credit, interest rates for personal loans can be very low, which is useful if you need to pay off high-interest debt. What’s more, personal loans are quick and easy to obtain. However, be aware that no credit check personal loans come with interest rates that typically exceed 99 percent.

Home Equity Loan or HELOC

If you have equity in your home, you can borrow against that equity with a long repayment term. A home equity line of credit (HELOC) allows you to use your home equity like a credit card, drawing funds when you need it and only paying interest during the initial period. You’ll then have a repayment period that is typically ten years or more. A home equity loan comes in a lump sum and requires fixed monthly payments. Tapping your home equity can be helpful if you have expensive home repairs that you want to pay off over time. However, you’ll need to pay closing costs, and the process can take a while. You may not see the funds for six weeks. That’s why these options work better for a planned expense than an emergency.

Zero Percent APR Credit Card

If you have excellent credit, one of the best ways to borrow is by opening a credit card with a zero percent introductory APR. You’ll just want to ensure that the introductory period, which is typically 15 to 18 months, is long enough for repayment. Otherwise, you’ll pay high interest on any remaining debt once the introductory period comes to an end. Furthermore, this option will only work if the amount you need to borrow is less than your credit limit.

The Bottom Line

Life doesn’t always go according to plan. In addition to contributing to your retirement account, you should save money in an emergency fund. That way, when emergency expenses arise, you’ll have the money to cover them, and you won’t be tempted to raid your 401(k). However, if you have found yourself in financial trouble and your 401(k) is your only safety net, taking out a 401(k) loan isn’t a bad idea, especially if you repay the loan with interest and continue making contributions while the loan is outstanding.