When it comes to retirement savings, there’s good news, bad news, and more bad news.
The good news is that most Americans today have access to a workplace retirement plan, such as a 401(k). A 2018 study at Stanford University found that roughly half of all U.S. households have access to a work-based retirement plan, such as a 401(k). And among workers who are eligible for these plans, about 90% in every age group are taking part.
The bad news is that most Americans don’t have enough in those plans. According to a 2020 Fidelity study, the average balance in a workplace retirement plan is only $104,400. That’s nowhere near enough to put you on track toward a comfortable retirement, even if you still have decades to go.
Now, for the other bad news: A significant percentage of Americans are hampering their retirement savings even further by borrowing from their 401(k) plans. According to Fidelity, nearly one in five participants in a 401(k) plan currently has an outstanding 401(k) loan. About 1.6% of all Americans borrowed from their 401(k) plans in the second quarter 2020, with an average loan amount of $12,600.
If you need money in a hurry, borrowing from your 401(k) may look like an easy fix. The interest is much lower than taking out a payday loan or running up a balance on your credit card. But 401(k) loans also come with significant risks — risks that could sabotage your entire financial future.
How 401(k) Loans Work
In most cases, once you’ve put money into your 401(k) plan, you aren’t allowed to withdraw it until you reach retirement age. If you take the money out any earlier than that — which is known as taking an early distribution — you must pay an early withdrawal penalty equal to 10% of the amount withdrawn, on top of any taxes you owe.
For instance, if you have $50,000 in your plan and withdraw $5,000, your balance drops to $45,000 and you pay a $500 penalty. (The CARES Act, a coronavirus relief bill passed during the 2020 COVID-19 pandemic, waived this penalty for the year 2020, as discussed below. The penalty will return at the beginning of 2021.)
However, you can get around this rule by borrowing the money from your 401(k) instead of withdrawing it outright. In this case, the balance in your plan stays at $50,000, but $5,000 of that is in the form of a loan you’ve made to yourself. As long as you pay the money back — with interest — within five years, you owe no penalty and no income tax.
Limits on 401(k) Loans
Companies don’t have to allow 401(k) loans, but most of them do. However, the Internal Revenue Service (IRS) sets limits on how much you can borrow. Typically, you can only take out 50% of your vested account balance, or the total of all your contributions plus whatever share of your employer’s contributions you would keep if you left your job today.
There are also some upper and lower limits on 401(k) loans. You can’t take out more than $50,000, even if your vested balance is greater than $100,000. However, if your balance is less than $20,000, you can still borrow up to $10,000. These are only the limits set by the IRS; employers are allowed to set lower maximums if they choose.
IRS rules allow you to have more than one 401(k) loan at a time, as long as your total loan balance doesn’t go over the maximum. However, most employers will only let you take out a second 401(k) loan if you’ve paid off the first one. Also, some employers only allow 401(k) loans for certain specific reasons, such as buying a home or paying for medical expenses.
Interest on 401(k) Loans
Unlike most loans, a 401(k) loan doesn’t require a credit check since you’re technically borrowing your own money. That makes it one of the easiest ways to get a loan if you have poor credit.
Most companies that administer 401(k) plans set the interest rate for 401(k) loans at around 1% above the prime interest rate, regardless of what your credit score is. However, this interest doesn’t go into the pockets of a lender. Because you’re borrowing from yourself, the interest goes right back into your own account. It’s one of the features that make 401(k) loans so tempting to borrowers and can lead them to overlook their dangers.
Pro tip: If your employer offers a 401(k), check out Blooom, an online robo-advisor that analyzes your retirement accounts. Simply connect your account, and you’ll quickly be able to see how you’re doing, including risk, diversification, and fees you’re paying. Plus, you’ll find the right funds to invest in for your situation. Sign up for a free Blooom analysis.
Problems With 401(k) Loans
People choose to take out 401(k) loans for a variety of reasons. They may borrow to get money for a down payment on a house, pay for college costs, cover high medical bills, pay for expensive home repairs, pay back taxes, or pay off other high-interest debt.
All of these are good reasons to borrow money, and a 401(k) loan offers an easy way to do it. Because there’s no credit check involved, it’s easy to get approval for this type of loan, and the interest rates are fairly low. And because you’re technically borrowing from yourself, it seems like there’s no way you can lose.
However, a 401(k) loan isn’t free money. It’s a risky choice that costs you in the near term and could sabotage your retirement savings for years to come. And if you can’t pay the loan off in time, you’ll face a hefty penalty that will deal an even bigger blow to your finances.
Here are six reasons a 401(k) loan is often a bad idea.
1. Lower Paycheck
Like any debt, a 401(k) loan must be paid back, and those payments come out of your current income. Some 401(k) plans take payments directly out of your paycheck so that you won’t risk missing one. That means that until you pay back the loan, every single paycheck you receive will be smaller.
Even if your plan doesn’t do this, you’ll still have to set aside money in your monthly budget for the loan repayment, which will leave you less for everything else.
If you’re on a tight budget already, this extra expense could make it hard or even impossible to make ends meet. At best, you’ll have to tighten your belt even further, skimping on luxuries such as entertainment or dining out. At worst, you could find yourself having to borrow still more — by running up a credit card bill, for instance — to keep paying all your bills.
2. Reduced Retirement Savings
Besides costing you money in the short term, a 401(k) loan sets back your retirement savings for the future. This type of loan is a triple threat, hampering the growth of your retirement savings in three ways:
- You Contribute Less. Many people stop contributing to their 401(k) plans, or don’t contribute as much, while they’re paying off a loan. In fact, according to Credit Karma, some plans don’t even allow you to make contributions to your 401(k) while you have an outstanding loan. That means if you take the full five years to pay off your loan, you’ll miss out on five whole years’ worth of 401(k) contributions, not to mention the returns you might have earned on those contributions.
- Your Employer Contributes Less. Many workers receive matching funds from their employers when they contribute to a 401(k) plan. For example, your employer could offer to match every dollar you put in up to 3% of your salary. So if you make $50,000 per year and contribute at least $1,500 to your 401(k), you get another $1,500 from your employer. If you cut that contribution down to $0 while paying off a 401(k) loan, your account doesn’t only lose $1,500 per year; it loses your employer’s $1,500 too, plus all the earnings on that $1,500.
- You Have Less Left to Grow. If you borrow $5,000 from your 401(k), that’s $5,000 less you’ll have in your account to earn money for you. Until you pay it back, the only return you’ll earn on that $5,000 is the interest you’re paying to yourself — and since that money is coming out of your own pocket, it’s not really a gain for you. Plus, when interest rates are low, you could almost certainly earn a better return by putting that money into other investments in your 401(k), such as stocks. The longer you take to pay off your 401(k) loan, the more your nest egg will shrink.
3. Interest and Fees
Although 401(k) loans have fairly low interest rates, they don’t always offer the best rate available. If you have reasonably good credit, you can probably get a lower interest rate with a different type of loan, such as a home equity line of credit (HELOC) through Figure.com. On the other hand, if your credit score is low, a 401(k) loan is likely to be your lowest-interest option, and if your credit is really low, a 401(k) loan could be your only option.
Of course, the interest you pay on a 401(k) loan isn’t wasted money since it goes into your own account. However, you also have to pay an origination fee of $50 to $100 for setting up the loan, and that’s a sum you won’t get back. On top of that, some 401(k) loans have administration and maintenance fees that last until the loan is paid off.
4. Extra Taxes
Borrowing from your 401(k) costs you more in taxes too. Typically, you contribute to a 401(k) with pretax dollars, thereby reducing your total tax bill. It’s one of the main advantages of using a 401(k) for retirement savings. However, if you borrow cash from your 401(k), you must repay the loan with after-tax dollars, missing out on those tax savings.
For example, say you’ve borrowed $5,000 from your 401(k). If you’re in the 25% tax bracket, you’ll have to earn $6,250 to pay back that $5,000 with after-tax dollars. Plus, the interest you pay on the loan also comes out of after-tax dollars. If your interest rate is 6%, that’s another $300 you have to pay, which means another $375 you have to earn.
Worse still, you’ll have to pay taxes on this same $5,000 yet again when you withdraw it in retirement. So by taking out a 401(k) loan, you’re actually signing up to pay taxes twice.
5. Repayment Risks
The biggest problem with a 401(k) loan is what happens if you can’t pay it back on time. If you haven’t paid off your loan at the end of five years, the IRS treats the remaining balance on your loan as an early distribution, and you must pay taxes on it as well as a 10% penalty.
For instance, suppose you take out a $5,000 loan, and at the end of five years, you’ve paid back only $4,000. The remaining $1,000 becomes an early withdrawal, and you must pay around $350 in taxes and penalties on it, all in one lump sum. According to a 2017 paper in the National Tax Journal, roughly 10% of all 401(k) borrowers have defaulted on their loans in this way.
In theory, you can get around this problem by simply making all your loan payments on time, but you might not get the chance. If you lose your job or change jobs, you lose access to your 401(k), which means the balance on your 401(k) loan comes due all at once.
In this situation, you have until the deadline for your next federal income tax return to either pay off the loan in full or roll it over into a new 401(k). If you can’t do either, it’s treated as an early distribution. The National Tax Journal study shows that 86% of borrowers who leave their jobs with an outstanding 401(k) loan end up defaulting on it.
6. Dependence on Debt
A final problem with 401(k) loans is that they can turn into a habit. According to a 2013 Fidelity study reported in The New York Times, a majority of 401(k) borrowers end up dipping into their accounts for extra cash again. The study looked at 180,000 people who had participated in a 401(k) plan over a 12-year period. It found that two-thirds of them had taken out more than one loan, 25% had taken out three or four, and 20% had borrowed from their 401(k) plans at least five times.
The article stresses that these borrowers aren’t necessarily “dysfunctional.” Most of them were people in their 40s and 50s, ages at which people have many competing financial needs, such as putting kids through college or caring for aging parents. Many of them could also be using these loans to deal with financial crises, such as job loss or high medical bills.
Still, the fact remains that by taking out repeated 401(k) loans to meet their financial needs, these borrowers are putting a serious dent in their retirement savings. According to the article, a borrower who takes out two five-year loans could end up with 13.8% less at retirement than one who takes out no loans. Borrowers who take out three loans would cut their retirement savings by nearly 19%, and those who take four loans would reduce their savings by 23%.
Alternatives to 401(k) Loans
Because 401(k) loans can cause so many problems, most experts say you should take out this type of loan only as a last resort. If you need money in an emergency, consider these other options first.
1. Hardship Distributions
The main advantage of borrowing from your 401(k), rather than simply withdrawing the money, is that you avoid the 10% penalty for an early distribution. However, most 401(k) plans have special rules that allow you to take an early distribution without paying a penalty in cases of financial hardship.
Under IRS rules, you owe no penalty for an early 401(k) withdrawal if:
- You leave your job or get fired at age 55 or older
- You become completely and permanently disabled
- You have medical expenses that cost more than 10% of your annual income
- You need the money to pay court-ordered child support or alimony
- You die, and the money in your 401(k) is paid out to a spouse or other beneficiary
Company 401(k) plans can set their own rules to allow hardship exemptions for other types of financial emergencies as well. The IRS allows plans to grant exemptions for any “immediate and heavy financial need.”
Examples include buying a home, paying for college costs, paying for major repairs to your home as a result of a natural disaster, dealing with major medical expenses, making necessary payments to avoid losing your home to foreclosure or eviction, and covering funeral expenses. If you take a distribution for any of these reasons, you must pay taxes on the money you withdraw but no penalty. Check with your plan’s administrator to see whether it allows this type of exemption.
Under the CARES Act, losses due to the coronavirus pandemic are also treated as hardships. You can withdraw up to $100,000 from your 401(k) with no penalty if you or an immediate family member becomes ill from COVID-19 or if you suffer financial losses due to the pandemic. This includes losing your job, being unable to start a new job as planned, having your hours cut, the closing of a business you own, or being unable to work because you can’t get child care. However, this exemption applies only through the end of 2020.
The main benefit of taking a hardship withdrawal instead of a loan is that you don’t have to pay back the money. However, this also means that you set back your retirement savings even more than you would by borrowing the money temporarily.
Still, taking a hardship distribution allows you to avoid the interest and fees associated with a loan, and it creates no risk of debt dependence. And even though you can’t “pay back” the money you withdraw, you can try to make up for it by increasing your contributions to your 401(k) in the future.
2. Other Types of Loans
A 401(k) loan isn’t the only way to borrow money, and for most people, it isn’t the best way. Here are some other types of loans to consider:
- Home Equity Loans or HELOCs. If you own your home, you can borrow against it with a home equity loan or home equity line of credit (HELOC). These loans typically offer modest interest rates and, in the case of a HELOC, flexible repayment terms. And if you’re using the money for home repairs or improvements, you can even deduct the interest on your taxes. For a HELOC loan, look into Figure.com.
- Personal Loans. If you have good credit, you can likely qualify for a decent rate on a personal loan. You can use a personal loan for any purpose, and you typically don’t need collateral for it. However, you’ll probably pay higher interest on this type of loan than you would for a home equity loan. Credible is a great place to start your personal loan search. You’ll receive up to 11 different rate quotes from lenders in just two minutes.
- Student Loans. For college costs, taking out a student loan makes more sense than borrowing from your 401(k). Rates aren’t too high, and the interest is often tax-deductible.
- Workplace Installment Loans. Some employers work with third-party services, such as Kashable, to provide low-cost loans to their workers. Employees can pay off the loans through payroll deductions, just like a 401(k) loan, but without putting their retirement savings at risk.
3. Debt Repayment
If you’re considering a 401(k) loan to pay off other debts, such as medical bills or back taxes, talk to your creditors first. See if they’re willing to work out a long-term repayment plan to pay off your debt in manageable installments. If they are, you might be able to pay off your debts over the same five-year period as you’d get for a 401(k) loan, but with lower interest and fees. Some medical providers are even willing to let patients pay off their bills gradually with no interest at all.
If your creditors don’t want to negotiate, try talking to a credit counselor. These agencies can often help you set up a debt management plan (DMP) under which you make monthly payments to the counselor and the counselor pays your creditors. Sometimes, a DMP can reduce the interest or penalties on your existing debts. However, there are also fees to set up and maintain one, so check to make sure paying your debts this way won’t cost more in the long term.
4. Alternatives to Borrowing
Sometimes, it’s possible to deal with emergency expenses without taking on any new debt at all. Take a look at your budget and see if you can squeeze out the extra dollars you need by trimming back your everyday expenses. Consider canceling cable or moving to a less expensive service like Sling TV, switching to a cheaper cellphone plan, slashing your grocery bill, or finding a cheaper apartment.
If you can’t muster up the money you need by cutting back, consider whether you can earn more instead. Ways to make extra cash include selling stuff online, putting in some extra hours at work, getting a side gig, or starting a side business.
When to Consider a 401(k) Loan
Despite their drawbacks, there are a few situations in which 401(k) loans could be better than the alternatives. If you’ve exhausted all your other options, it’s worth considering a 401(k) loan for:
- Paying Tax Debts. If you owe back taxes or other debts to the IRS, it can file a tax lien against you giving it a claim on all your assets. A tax lien makes it hard or impossible to sell a property or refinance a mortgage, and it often can’t be eliminated through bankruptcy. In extreme cases, the IRS can even seize your property through a tax levy. Dipping into your retirement savings to avoid or pay off a tax lien or avoid a tax levy is probably the lesser of two evils.
- Avoiding Bankruptcy. A 401(k) loan could also be worthwhile if the only alternative is bankruptcy. Although you can protect some of your assets during bankruptcy, such as your home, it will damage your credit score for years to come. And even after the bankruptcy comes off your credit report, it remains a matter of public record that can damage your chances of getting a job, professional license, or security clearance for a government job.
- Buying a Home (Maybe). If you dip into your 401(k) for a down payment on a home, some plans give you extra time to pay back the loan. That reduces the impact on your paycheck, but it doesn’t eliminate the other risks associated with this type of loan.
If you absolutely must take out a 401(k) loan, you can mitigate the risks by borrowing as little as possible and committing to the shortest possible repayment term. That limits the amount by which you’ll be shortchanging your retirement fund, and it also reduces the risk that you’ll change jobs before the loan is paid off.
The best way to avoid having to take out a 401(k) loan is to avoid getting into a situation where you need cash in a hurry. By creating and sticking to a household budget, you can ensure that your everyday expenses don’t get out of control. Make sure to set aside money in your budget for once-in-a-while expenses, such as home and car repairs, so that they don’t derail your budget.
Of course, even the best budget can’t cover everything. You can set aside money for the brake job you know you’ll need one day, but you can’t budget for a major illness, injury, or natural disaster. However, you can plan for unexpected expenses by carrying plenty of insurance and by having a well-stocked emergency fund that can see you through a crisis.