401(k) loans: The good, the bad and the bottom line

Stuart Robertson
Nov 4 · 3 min read

We’ve all been in that bind — sideswiped by a sudden, semi-exorbitant expense that has your head spinning and your mind scrambling to come up with options to cover it.

Do you max a credit card, take out a second mortgage, HELOC or payday loan? Swallow your pride and ask aunt and uncle Moneybags for a personal loan you’ll never be allowed to forget? But what about that sizeable stash you’ve been contributing a portion of your income to since your late twenties — your 401(k)! That is technically your money, right? Could that be a better solution? Well, not so fast…

If you’ve been fortunate and forward-thinking enough to invest in an employer-sponsored 401(k) over a number of years, good for you. You’ve likely benefitted from some significant tax savings and witnessed the power of compounded growth while building a nest egg for your future. (Unfortunately many Americans have yet to do that.)

But with those tax savings and other benefits — offered and controlled by good old Uncle Sam — come some rules and restrictions on your ability to access that money, and what it will cost you if you try to access it before you reach retirement age.

Here’s a high-level view the pros and cons of taking a loan on your 401(k). First, you’ll need to see if your plan has the option of providing a 401(k) loan. If it does, keep in mind every 401(k) has some flexibility in setting its own rules and requirements, so you’ll want to confirm how yours works.

The Good

· You can generally take a loan on your 401(k) of up to 50 percent of your vested balance, up to $50,000.

· You can do it without a credit check because you’re technically borrowing from yourself.

· Interest rates are typically low, and you’ll be paying the interest to yourself (not a bank or other lender) so all that money technically goes right back into your account.

· You typically will be paying back yourself over a 5-year period automatically from each paycheck.

· Most 401(k) loans have a low charge to access — but you’ll want to double check.

The Bad

· If you quit, switch or lose your job (from the company that sponsors your 401(k)), Uncle Sam will expect you to pay back the unpaid balance of your loan within 30–60 days, or this unpaid balance will be considered a taxable distribution. You’ll not only need to pay taxes on these dollars, but if you are under 59 ½ years of age, you’ll also owe an additional 10 percent tax penalty at tax time for early withdrawal — ouch.

· Taxes continued. You’ll have to pay the loan back via your paycheck which is after-tax dollars, and like most all tax-deferred 401(k) contributions, you’ll pay tax on the money again when you withdraw it in retirement.

· You’ll need to play catch-up on your retirement savings, which (among most things) gets tougher with age.

· These loans aren’t always fast to process. It may take a few weeks, so make sure you have time.

The Bottom Line

Taking a loan on your 401(k) is certainly possible and should be a consideration for certain emergency circumstances. It can even be a smart choice (for example, it may actually save you money compared to paying exorbitant interest rates on another loan or credit card) if you feel confident you can pay it off quickly and within the terms set by the plan, and if the benefits outweigh the costs. But these types of loans should generally be considered a last resort, and for good reason — they can set your retirement back and create a big tax bill that leaves you in an even more expensive bind should you lose or quit your job or ability to pay it back within the set terms.

Stuart Robertson
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