A financial crunch could happen when gas prices or inflation are high. This could tempt you to tap into your 401(k) plan. Yet, the interest rate on 401(k) loans is typically a point or two higher than the prime rate. To be able to retire when and how you want, it's crucial to maintain a long-term perspective while attending to your immediate needs.

This guide gives you a brief narrative of the benefits and drawbacks of 401(k) loans and withdrawal amounts, along with alternate solutions.

How Borrowing From Your 401(k) Works

Employers may offer a 401(k) that allows workers to borrow against their accounts, though not all plans may allow this. Here's how it works, step-by-step:

1. Contact your human resources department or benefits manager.
2. Find out if loans are allowed in your 401(k) plan and how you will repay them.
3. Go to the website you use for other 401(k)-related activities.
4. Submit a loan request application online.
5. The application online will not allow you more money than is legally permitted to borrow.
6. It will sum the interest rate and payroll deduction based on a typical five-year payback schedule.
7. The approved sum will likely get deposited straight into your direct checking account or be received as a cheque.
8. The interest payments return to your account – you are essentially paying interest to yourself.

These days, applications are usually submitted online. You can contact the fund managers on the website for any queries.

How Much Can I Borrow?

The IRS limits the amount you can borrow. If you have $100,000 or more vested, you can borrow up to $50,000, or 50% of the account's vested value.

You will be allowed to borrow up to $10,000 if your account balance is less than $10,000. Make sure to evaluate your "vested" account balance.

Repayment Terms on 401(k) Loans

A 401(k) loan typically has a five-year term. Even though you might be able to negotiate a shorter duration if this is what you prefer, it is the maximum repayment duration the government permits. 

But the exemption is if you want to use the funds to purchase your residence or permanent home. If so, you may borrow money for up to 25 years under some plans. If you pay off the loan before the term limit, there are no penalties.

Drawbacks to 401(k) Loans

Consider the following drawbacks of this decision before deciding whether to borrow from your 401(k):

  • You are using funds that would otherwise be working for you. There is an opportunity cost associated with passing on potential growth.
  • If you take out a 401(k) loan, the funds typically are derived from your account balance. Some plans divide the funds equally among all of your various investments. Therefore, supposing you have money in mutual funds, the total loan comes from each fund.
  • A key disadvantage is that even though you'll pay yourself back, you're still taking money out of your retirement account while it's still growing tax-free. Moreover, the less money you have in your plan, the less opportunity for it to grow.
  • Losing your job or leaving while still owing loan money may be the worst risk you are likely to face. If so, you'll generally need to pay back the entire amount within 90 days after leaving. You will default if you do not repay, and the remaining loan sum is considered a withdrawal. Then, the entire loan amount is subject to income taxes. In addition, the 10% early withdrawal penalty may be due if you're under 59½ years.
  • The biggest impediment in your retirement savings plan might result from losing years of retirement savings and your employer's contributing payments to your 401(k).

Here are more risks that you must consider:

  • The repayments are with post-tax money, which will be subject to further taxation when you ultimately take the money from your account.
  • Based on how they are estimated, the costs you pay to arrange the loan can be more than on a traditional loan.
  • It doesn't matter if you utilize the money to purchase or improve your property; the interest is never deductible.
  • Retirement contributions are often postponed for debtors until the 401(k) loan gets repaid.

In addition, since withdrawals from 401(k) funds often get taxed as regular income, you won't receive the whole amount if you take a hardship withdrawal. Besides, unless you fulfill one of the IRS's exceptions, a 10% early withdrawal penalty is imposed on withdrawals made before age 59½.

Will a 401(k) Loan Affect My Credit?

A 401(k) loan does not require a credit check. A credit score is not necessary for loan eligibility. The lender will not pull your credit record for review because you already own the retirement funds.

If your 401(k) loan is approved, the new loan will not show up on your credit records. Your credit history will not get reported by the plan administrator to the credit agencies Experian, Equifax, or TransUnion.

Your credit ratings will remain unchanged even if you skip a payment or even go into loan default.

Note: While defaulting on a 401(k) does not lower your credit score, there may be other unfavorable effects. Your ability to pay your payments on time may be hampered by the added tax and penalties, which might indirectly affect your credit score.

Consider Other Alternatives

A 401(k) loan can be a wise choice based on your financial status. This kind of borrowing, though, can wind up hurting you in other circumstances. Consider all of your alternatives before borrowing. A few options to think about are listed below:

  •  If it's a genuine medical necessity, use your Health Savings Account.
  • Use emergency savings for a crisis.
  • Use additional non-retirement funds, including checking, savings, and trading accounts.
  • Borrow from a personal loan or a home equity line of credit.
  • You can get a personal loan with good terms if you have a suitable credit score.

Make sure you grasp all the terms of borrowing from your 401(k) if this is your only choice. It's crucial to have a repayment strategy in place as well.

Finally, keep an eye out for chances to pay off your 401(k) debt earlier than expected by making extra payments as soon as possible. You may start earning returns on your investment more quickly if you can pay off the loan.

About the author 

Greg Lorenzo

Greg is a financial expert who has been advising his audience on loans for over 10 years. He has a wealth of knowledge and experience in the area, and he is passionate about helping people get the best possible deal on their loans. Greg is an expert in negotiating loans, and he has a proven track record of getting his clients the best possible terms. He is also a strong advocate for financial literacy, and he regularly gives workshops and seminars on the topic.

Leave a Reply

Your email address will not be published. Required fields are marked

{"email":"Email address invalid","url":"Website address invalid","required":"Required field missing"}
Subscribe to get the latest updates