The Basics of Borrowing Against Your 401(k)

There are many ways to get to loan. Unfortunately, not everyone has a breadth of options in doing so. Although most financial experts don’t recommend it as one of the best avenues to get a loan, one of the ways to access money is to borrow against a 401(k).

Borrowing from a 401(k) is often best to use if a person doesn’t have a good credit history and better alternatives for borrowing. The loan should be used for something considered absolutely necessary.

A little more than 80 percent of 401(k) plans have loan provisions. For a loan of this type, you repay the principal amount you borrowed, plus interest, using after-tax dollars.

Many 401(k) plans allow a participant to borrow 50 percent of the vested portfolio value, or $50,000, whichever is less. The minimum amount you may borrow varies by plan, but many of the largest retirement savings companies have a $1,000 minimum.

Methods of repayment can vary. The most common way is through automatic after-tax payroll deductions, but other common ways are via electronic payments from your bank account or by personal check.

Tax professionals can give you more specific information about tax consequences related to a loan from a 401(k). Retirement plan companies often will explicitly tell their participants that they are not tax experts and to seek the help of a tax professional when analyzing the consequences of borrowing against a 401(k).

Here are some advantages of using a 401(k) for a loan:

1. You don’t need credit approval like you do for a traditional loan, since you’re borrowing your own money. One phone call or application form is typically all that’s needed.


2. Most loans are delivered to you within a week, while others can take only a few days, if you have a link set up between your bank and your retirement account. Express mail delivery — also taking a few days — is another option, but a small fee is usually attached to that service.


3. You’re paying interest that goes back into your account.


4. You avoid the 10 percent penalty for early withdrawal on your 401(k), unless you default on the loan.


5. You typically pay a low interest rate — often at, or slightly above, the prime rate.

If you must choose between withdrawing money from a 401(k) and paying a 10 percent penalty, or getting a loan against your balance, then chose the loan. If you have the option of taking out a home equity loan, that’s usually the better way to go, since you can usually deduct the interest on your taxes.

Here are the disadvantages of borrowing against a 401(k):

1. The more money you borrow, the less money that’s working for you in your retirement account. Although you can sometimes continue contributions to your plan, some plans may impose a contribution suspension period after you take a loan.


2. Because you will repay the loan through payroll deductions, your take-home pay will decrease.


3. You must repay the entire balance of your loan within a certain amount of time or pay a penalty of up to 10 percent — due to withdrawal, if you leave your job for any reason. The tax penalty applies to those younger than 59 ½. A defaulted loan amount will be reported to the IRS as a taxable distribution from your retirement plan.


4. You must pay state and federal income taxes on the loan amount, if you leave your job for any reason — either voluntary or involuntary.


5. There are often fees for setting up the loan — such as initial setup and annual loan maintenance fees.


6. If used for a home purchase, there’s no interest deduction on your income taxes, unlike the interest deduction for a mortgage.

You usually have five years to pay back the loan, but plans can vary. If you’re using the money to buy a home, then the payback time is longer. Most loan repayments begin within two pay cycles.

One area of possible concern — your credit score — is not affected by a 401(k) loan, even if you default on the loan, since your 401(k) balance serves as collateral.