How do 401(k) loans work and are they right for you?

The 401(k) plan is ubiquitous when it comes to retirement planning — millions of Americans regularly contribute to them. 401(k)s are pretty iron-clad savings vehicles as it can be difficult to withdraw money prior to your retirement age without hefty penalties and tax consequences.

However, many retirement plans do allow people to take out loans from their 401(k) accounts. And people take advantage of this — about 20% of plan participants currently have an outstanding 401(k) loan, according to the Employee Benefits Research Institute (EBRI).1

But is taking a loan against your 401(k) really a good idea? Let’s take a closer look and explore what your options are when it comes to borrowing against your 401(k).

Does it make sense?

First, let’s address the elephant in the room: Is it ever a smart idea to borrow money from your 401(k)? After all, the primary purpose of contributing to a 401(k) for most people is to save money for retirement. Could you be jeopardizing your financial security if you take out a 401(k) loan before you retire?

We generally say yes, you possibly could put your future retirement security in danger. In fact, this is probably the biggest drawback to taking out a 401(k) loan. Borrowing money from your 401(k) means that you miss out on the potential earnings that could have accumulated in your account due to the long-term compounding of returns. Typically, borrowing against your 401(k) is simply not worth it in the long run and can have serious negative consequences on your ability to meet your retirement goals. To see what compounding can mean for your retirement nest egg over time, read more about the average 401(k) by age.

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Another reason that you should avoid borrowing against your 401(k) is that if you leave your job or are terminated before you’ve repaid the loan, you might have to pay income taxes and a penalty on the outstanding loan amount (if you are younger than age 59½.)

The lowdown on 401(k) loans: How do they work?

While we almost always recommend against 401(k) loans, if you absolutely must borrow against your 401(k), you’ll be glad to know that the interest rate is usually less than the rate on some other types of consumer loans. And since the interest accrues in your account balance, you’re paying it to yourself, not to a bank or other lender.

Filling out a 401(k) loan application can often be done online in a matter of minutes and the process doesn’t generate a credit inquiry or impact your credit score. There’s also a lot of repayment flexibility: IRS regulations require that 401(k) loans be repaid according to a five-year amortization schedule, but you can repay the loan faster if you want through payroll deductions.

In general, you can borrow up to $50,000 from your 401(k) or 50% of your vested account balance, whichever is less. There are no restrictions on the purpose for a 401(k) loan, so you can use the money for any reason you choose.

Some reasons people decide to take a 401(k) loan

  • They need money for a home down payment. Saving enough money for the down payment is one of the biggest obstacles many people face when buying a home. Due to special rules that allow more than five years to pay back a 401(k) loan used for a down payment, some people opt to tap their retirement savings for this purpose. However, buying a house may not always be the wisest financial decision, especially if you must use your retirement savings to fund the purchase.
  • They’re coming up short on college savings. With student loan debt in the U.S. now exceeding $1.75 trillion,2 many parents are hoping to save enough for college that their kids can graduate debt-free. Some parents opt to use their 401(k) funds to help pay college costs, but we strongly advise against this. Remember, you can always borrow for education, but you can’t borrow for retirement.
  • They need to make major home improvements or repairs. Many people use home equity lines of credit (or HELOCs) for these purposes, but some people decide to take a loan from their 401(k) instead because HELOCs usually have adjustable interest rates. However, we’d still advise caution here because again, taking money out of your 401(k) will almost always be costly to your retirement savings.
  • They are facing large out-of-pocket medical expenses. Higher deductibles and copays mean large out-of-pocket medical costs for many people, so this is another reason many folks seek out 401(k) loans.
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Our take: Weigh the pros and cons

There are pros and cons to borrowing money from your 401(k) that you should carefully consider before taking any action. We would generally advise against taking a loan out against your 401(k) — it is usually just too costly, as missing out on compounding can make a much bigger dent in your retirement savings than you might imagine.

Everyone’s situation is unique, so your financial professional can help you decide what will work best for your specific circumstances.