A 401(k) loan is an enticing prospect during financial hardship, and may seem more preferable than a withdrawal, but the risks are vast.
If you’ve had a standard full-time job for any amount of time, you’ve also (hopefully) opened up a 401(k) or equivalent.
The 401(k) is an investment account that allows you to contribute money from your paycheck with tax advantages, often (but not always) advantages that you see immediately in your paycheck. I believe that the 401(k) is the most lucrative investment product for most people.
This money is yours, and let there be no dispute of that. But because you have entered into a tax-advantaged arrangement, utilizing the money comes with some constraints:
- The money is considered taxable income upon withdrawal*.
- If any money is withdrawn before age 59 1/2, you will be charged a 10% penalty.
* Not talking about the Roth 401(k) here, but most people don’t have this.
The cost for taking an early withdrawal can be significant. Assuming a 25% tax bracket (for easy math), a $50,000 withdrawal will be taxed at $12,500, and a 10% penalty will be an extra $5,000 on top of it. So you will end up with only $32,500, two-thirds of what you withdrew.
(There are hardship withdrawals too, which alleviate the 10% penalty, but those are still treated as taxable income.)
But what if you want to get at that money sooner? There is another option where you can take a loan out from your 401(k) and then pay it back over time. In this case, there are no massive penalties.
It might seem like a perfect option. But in reality, it’s far from perfect.
Table of Contents
How does a 401(k) loan work?
The short answer is it depends. These loans are governed by your 401(k) servicer, and not all details are the same.
But in general, you can take a temporary distribution of up to $50,000 or 50% of your balance (whichever is less). You will then have a maximum of 5 years to pay back the money to your account.
You will have to pay interest on this transaction too, which also varies but tends to be the Prime Rate plus 1-2%. At today’s rates, that’s around 10%.
This may seem steep, but in a weird quirk that comes from borrowing money from yourself, the interest actually goes back into your account. So you could technically add money to your account by taking a 401(k) loan!
What’s not to like?
Beware of job loss
This all sounds good so far, but there is one giant snag that makes this a very risky idea.
Since 401(k) plans are tied to your job, your loan is also tied to your job.
If your job ends for any reason, you have to pay back the entire balance of the loan, typically within 60 days. So if you have used that money for something else, tough luck, the balance is due anyway.
Failure to pay back the whole amount will make the loan be treated as a withdrawal, meaning that you’ll incur all those penalties and taxes we talked about above.
Now, I know you might be thinking that your job is 100% safe, that there’s no way that this is relevant to you. But even in stable situation, black swan events occur, and what seems like a rock-solid job may become the next video store clerk. And these shifts can happen fast; after all, five years ago, who anticipated that betting on commercial real estate would be a terrible investment?
So the longer you hold this loan, the riskier it gets.
When would be a good time for a 401(k) loan?
I have to be honest, I can’t really see many situations where a 401(k) loan would be a truly good idea. Maybe if you needed a lot of money but were guaranteed to be able to pay it back very quickly, but that’s a pretty rare situation.
The most obvious reason would be “in an emergency”. But emergencies are the worst times to take on debt. To misquote Jamie Zawinsky, or whoever said it first:
“Some people, when confronted with [an emergency], think ‘I know, I’ll [take out a loan].’ Now they have two [emergencies].”
Money thrown at an emergency may seem like you are tackling a problem, but you
may just be substituting one problem for another.
Instead, when you’re dealing with financial hardship, you would instead be better off served by trying to:
- Negotiate with your creditors. No one wants to deal with non-payment issues, not even lenders. It’s worth a call, and maybe even another one.
- Cut unnecessary expenses. It’s probably not going to solve every problem, but it will certainly help.
- Explore government assistance programs. While the U.S. sucks at the social safety net, there are programs out there that can help, such as unemployment, SNAP benefits, or housing assistance.
- Lean on your community. The hardest part is asking for help. The second hardest is accepting it. But giving help is what we’re wired to do.
- Talk with a financial counselor. That’s someone like me, though you can find many others at Find an AFC.
A 401(k) loan might be an option for you, but it’s one not to be taken lightly. It’s probably not worth the risk. After all, it’s your retirement money; don’t squander it.