Generally, you may be able to borrow money from your 401(k) plan account if your employer's plan offers loans. Many 401(k) plans allow you to borrow up to 50% of your vested account balance, up to a maximum of $50,000, before you retire. Because rules vary from plan to plan, you should check with your plan administrator to be sure. But it might not be a good financial move.
It's important to understand the possible effects an early withdrawal could have on your retirement account and your overall finances. As with any financial decision, it's important to educate yourself on the pros and cons of each option before making a choice.
Weigh your options carefully
Some experts say that you should never take a loan from your retirement account, because of its potential to derail your retirement investment progress. Yet the truth is that there are a few circumstances when you may want to consider it.
- You need fast access to cash. If you're in an emergency situation and need money immediately — say, to repair your home after a natural disaster or to deal with an unforeseen medical situation — a loan from your retirement account might be a viable option.
- It makes financial sense for your situation. In some cases, a plan loan, even with all its potential drawbacks, might help you get out of a bad financial situation. For instance, you may be able to pay off a high-interest credit card. You will generally be charged an interest rate similar to the rate you would pay for a bank loan, there is no credit check, and you pay the interest to yourself rather than to a bank or credit card company.
- You need it to make a down payment on a home. If you're considering purchasing a home, a higher down payment could lower the interest rate on your mortgage in some cases. Just remember that if you take out a loan from other lending sources, the interest typically will be tax-deductible. That's not the case with a retirement plan loan.
Potential disadvantages
As appealing as it may seem, taking a loan from your retirement account has potential disadvantages.
- You'll reduce your take-home pay. Understand that loan payments will come out of your paycheck (as they ultimately would for any other loan). This means that until your loan is paid in full, you'll have to learn to get by on less. Before pulling the trigger, be sure to calculate the net effect on your take-home pay.
- You may lose momentum. Due to your reduced take-home pay, you may need to reduce the amount of contributions to your account while your loan is outstanding, depending on your disposable income. In addition, although not common, some plan loan policies won't let you make additional contributions to your account until your loan is paid in full, essentially causing you to put your retirement investment progress on hold.
- You might face additional taxes. If you lose or leave your job before your loan is paid off, you may be on the hook to pay the loan back in full in a short time period, or it will be treated as a distribution and taxed accordingly. This is referred to as a loan "offset." The outstanding amount may be subject to federal and, if applicable, state income taxes, as well as an additional 10% federal income tax for early withdrawal if you're under age 59½, unless an exception applies. However, you may avoid this tax treatment by repaying or rolling over the unpaid loan amount to a new employer's 401(k) plan or an IRA, as long as this is done by the federal income tax filing deadline, including extensions, for the year in which the offset occurred.
- You could miss out on valuable compounding time. When it comes to investing for a long-term goal like retirement, time truly is money. That's because of compounding — the ability to potentially earn money on your money. With compounding, the money you invest has the potential to grow, and those earnings may also grow. When you take your money out of the market, you might miss out on valuable “money earning money” compounding time.
When it may not be a good idea
There are a few situations where you may not want to take a loan from your plan account — for example, to pay for college. The argument against borrowing from retirement to pay for a child's college education is simple: generally speaking, college loans are readily available (and the interest is potentially tax deductible); however, you cannot borrow money to pay for retirement.
Do I have to pay taxes on a 401(k) loan?
If you leave your employer before the loan is paid off, you may owe federal and state income taxes on the distribution — on top of a 10% additional federal tax if you're under age 59½ — unless an exception applies. You generally have until your tax filing deadline (including extensions) for the year in which the loan was treated as a distribution to make a rollover to an eligible retirement plan (equal to the amount of the distribution) to avoid being taxed. Consult your tax advisor if you're considering this option.
How do hardship withdrawals work?
If your employer's plan allows, you can apply for a hardship withdrawal if, for instance, you're facing eviction or need to pay for certain medical expenses. Your withdrawal typically will be treated as taxable income. Another consideration: A hardship withdrawal permanently reduces your retirement account balance and gives you no option to repay, which can make it difficult to get back on track with your retirement savings goals.