What is a 401(k) Loan and How Does it Work?Published on January 22, 2021 by Daniel Azzoli
One of the most important things you can invest in is your retirement. After a lengthy career full of long hours and hard work, you’re going to want the comfort of knowing that when your working days are over, you’ll have the money set aside to live out your retirement without having to stress about your finances. So the thought of touching the hard-earned money you’ve invested through your 401(k) before your retirement might seem crazy. But if you find yourself in a situation where you need funds fast and you have no other place to turn to, taking money from your 401(k) might be a potential option.
This isn’t a decision that should be made lightly or without exploring what this could mean for your long-term financial standing. In order to make an informed and safe choice, you’ll need to understand the process, the implications, and you’ll need to make sure you balance your long-term financial outlook with your current needs.
Today, we’re going to go over what a 401(k) is, the differences between borrowing from a 401(k) loan and making a withdrawal, instances where using a 401(k) loan may make sense, and some potential alternatives.
What is a 401(k)?
Before we get into 410(k) loans, we should talk about what a 401(k) is in the first place. This is essentially an investment/savings account that is offered by employers to their workers, and comes with certain tax-related advantages.
Typically, an employee will direct money into their 401(k) by having their employer take a portion of their salary and invest it into this account, and the employer will then make an equal or partial contribution to the employee’s account as well. The percentage of your contribution that they match will vary between different employers. The earnings of the money you invest into a traditional 401(k) won’t be taxed until you finally withdraw the funds, which you’d typically do once you’ve retired.
On top of traditional 401(k)s, there are also Roth 401(k)s. These operate in a similar way to their traditional counterpart, but instead of not being taxed when you initially make your contributions, you’ll be taxed initially and not when you withdraw your funds.
401(k) Loan vs. Withdrawal
Like we said before, making the decision to draw funds from your 401(k) before you retire is a big one, so it’s important that you understand the potential avenues you can take and what the consequences may be for each.
If you do end up taking money out of this account, you typically have two ways of going about it. You can either take what’s called a hardship withdrawal, or you can take a 401(k) loan. Let’s take a look at both options.
When it comes to a hardship withdrawal, you’ll need to meet certain requirements outlined by the Internal Revenue Service (IRS) in order to take one out. Broadly speaking, you may be able to go this route if you have some sort of time-sensitive and substantial need for money. If you do fall into this category, the money you withdraw will be taxed as income normally would be, and if you’re below the age of 59 and a half, you’ll face a withdrawal penalty of 10 percent.
If your need is substantial enough, you may be granted a safe harbor exception by the IRS. These are classified as substantial financial needs that require immediate attention, and you won’t be able to withdraw an amount that exceeds the needs of the financial emergency you’re facing. Situations that could qualify you for a safe harbor exception may include:
- Emergency medical needs, like the cost of emergency surgery.
- Funds to avoid eviction from your principal residence.
- Funeral expenses.
- Home repair expenses, assuming it’s for an emergency.
If you’re looking for a way to withdraw money from this account but you’re not necessarily facing an immediate financial emergency, a 401(k) loan might be an option. But how does a 401(k) loan work?
For starters, it’s not exactly what you might think of when you think of a traditional loan, as there’s no lender involved and your credit history won’t need to be checked. A more accurate definition would be that it’s a way to get a hold of a portion of the money you’ve put towards your retirement, and to do so tax-free. But you likely won’t be able to access as much as you’d want. You can get hold of either 50 percent of what you’ve contributed, or up to $50,000, whichever comes first. You’ll then need to repay this money and bring your 401(k) account back to what it was before you took out this loan.
Like any major decision, there are going to be pros and potential cons. For starters, with a traditional loan, the money you receive and then subsequently pay back typically begins and ends with the financial institution providing the funds. But with a 401(k) loan, you’re essential withdrawing money from yourself and then paying yourself back. While this loan may come with interest, the interest you pay goes back into your account, which may actually add to the contributions you’ve made towards your retirement.
On the other end of the spectrum, if you leave your current employer (who is matching your contributions) and you aren’t able to pay back what you’ve borrowed in a specific span of time, you will have defaulted on your loan and this will be considered a regular distribution. This means that you’ll need to pay income taxes on the income made from it as well as an early withdrawal penalty.
4 Reasons Why You Might Consider a 401(k) Loan
While your retirement savings are generally meant to be left untouched until you actually retire, there are a few reasons why borrowing from your 401(k) may not be a bad idea when you need money for immediate cash needs.
1. Minimal Extra Cost
In order to take out a 401(k) loan, you won’t need to pay exorbitant fees. While there may be one or two small fees (like an origination fee), that’s usually the end of it.
2. It’s Quick and Easy
Generally speaking, the process of getting a loan through your 401(k) is relatively straightforward and quick. There typically won’t be an inquiry into your credit history, so your credit score won’t be affected.
3. Increased Retirement Savings
Like we mentioned earlier, 401(k) loans do come with interest as part of your repayment, but all the money you repay (including the interest) goes right back into your retirement fund. So, as long as you meet all your payments, you may actually increase your retirement savings once the loan is fully paid off.
4. Flexible Repayment
When you’re paying back your 401(k) loan, you’ll do so over a 5-year repayment schedule. However, there are certain details that can make this repayment less stringent than it sounds. First off, if you want to pay it off faster, you can do so without incurring an early repayment penalty. Secondly, with a lot of plans, you’ll be able to make your repayments through deductions in your payroll.
Alternatives to a 401(k) Loan
While there may be reasons why it could make sense to take out a 401(k) loan, there are also other alternatives that may work better for you depending on the situation you find yourself in.
Build an Emergency Fund
An emergency fund is basically what it sounds like. It’s money that you save away specifically to help you deal with emergency expenses in the future. This could be for things like unexpected medical expenses, urgent car repairs, or essential home repairs. It’s not meant to be used for things like vacations, shopping, or non-essential expenses. When it comes to emergency expenses, your emergency fund should be your first line of defense. Learn more about how to build one here.
Personal Line of Credit
If you run into an emergency expense and you either don’t have an emergency fund, or your emergency fund isn’t big enough to cover it, a personal line of credit may be a potential option to help close the gap.
A line of credit is a form of revolving credit where you’ll be able to request draws against a pre-determined credit limit. You can draw funds whenever you need money, as long as you have available credit and your account is in good standing. As you pay off your balance, you can continue to borrow money when you need it.
Click here to learn more about lines of credit.
Consider Your Options Carefully
When you’re saving up for retirement, you’ll generally want to have a consistent stream of money going into your retirement fund that will remain untouched until the day comes when you call it a career. But the path to retirement is rarely a straight line, and there’s a good chance that you’ll experience bumps along the way. If you do end up in a situation where you feel like taking a 401(k) loan is the right move, make sure you consider the consequences before making any firm decisions.
If you want advice from a professional that’s geared towards your specific circumstance, consider speaking to a financial planner. Otherwise, we hope this article helps!