401(k) Loans: When It Makes Sense To Take One

401k written n gold on a table

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Once in a while, you may need some extra cash, and you may wonder if you should take a loan from your 401(k). Taking a 401(k) loan has several advantages though one should only generally take a 401(k) loan for specific reasons.

In this post, I'll discuss when it makes sense to take a 401(k) loan and some of the pros and cons of doing so.

Withdrawal vs. Loan

First off, let's talk about the difference between a 401(k) loan and a 401(k) withdrawal. When it comes down to it, a loan is something you pay back to your 401(k) each month, whereas a withdrawal is a permanent removal of money from your account.

401(k) Withdrawal

When you withdraw money from your 401(k), you pay a 10% tax penalty on the money if you're under 59½. That said, the money is yours to keep.

Note that under the CARES Act, you may be eligible to waive the 10% withdrawal penalty tax up to a $100,000 withdrawal if you, your spouse, or a dependent has been diagnosed with COVID-19 or COVID-19 has caused you to incur a financial hardship.

Pros of a 401(k) Withdrawal: When you withdraw money from your 401(k), you are not required to pay it back.

Cons of a 401(k) Withdrawal: Withdrawing money from your 401(k) will hurt your retirement nest egg because you may have considerably less money to grow over the years. That, combined with the 10% penalty tax, can hurt you in the long run.

401(k) Loan

When you take out a 401(k) loan, you borrow money from your retirement nest egg. Depending on your employer's plan, you can take out as much 50% of your account's value, up to a maximum of $50,000 within a 12-month period. In most cases, you'll have to pay your loan back within five years, and you'll also be charged interest.

Pros of taking a 401(k) loan: With a loan, you don't have to pay taxes and penalties. Additionally, you don't take a hit to your credit score when you take a loan from your 401(k).

Cons of taking a 401(k) loan: If, for some reason, you leave your job while having an outstanding loan, you may have to repay the loan in a short period of time. You also lose out on potential short term and long term growth of your retirement money when the money is not in your 401(k).

When Should You Borrow From Your 401(k)?

Sometimes it makes sense to take a loan from your 401(k). Check with your 401(k) plan information or plan administrator about interest rates and terms and conditions. Taking a loan from your 401(k) is generally better than personal loans, and most certainly a better idea than ever using payday loans.

Here are three reasons when to take a loan from your 401(k):

1. Make a Down Payment on a House

Buying a home is often the largest expense one will take. Putting more money down on a home purchase lowers your monthly payment over the course of the mortgage and can help you avoid PMI.

Consider whether you want to buy a house now or if you can wait until you have enough money saved. Sometimes a dip in the housing market or extremely low interest rates makes it the perfect time to buy. During the 2020 Coronavirus pandemic, interest rates dropped to record lows making it a great time to buy a house.

Related Post: 15 Year Mortgage vs. 30 Year Mortgage: Distinct Advantages

2. Pay Down High Interest Debt

If you have a lot of credit card debt, or other high interest debt, using a 401(k) loan can be beneficial. That said, before you take out such a loan for high interest debt, you should look into all other options as the long-term drawbacks of the loan may outweigh the benefit of paying off your debts.

This will all depend on your high interest debt balances, how much you plan to take from your 401(k), your 401(k) total balance, and how many years you plan to continue contributing before you retire.

Remember, you won't need to have your credit checked with a 401(k) loan, which may make it ideal to pay off other high interest debt versus taking out a personal loan to do the same.

3. During a Financial Hardship

Consider the situation where you or your significant other lose their job or have an emergency, such as illness. You may need a financial hardship withdrawal from your 401(k) but not want to take tax penalties. Instead, you can take a 401(k) loan and cover your expenses for the time being. This extra money can keep you afloat financially while your hardship passes.

A financial hardship can sneak up on anyone, and having some of your retirement money on hand can save you from sinking into debt.

Why Should You Take a Loan From Your 401(k)?

Borrowing from your 401(k) is beneficial versus taking out a personal loan or finding other means to secure the money for multiple ways that include:

1. Convenience

Getting a 401(k) loan is relatively quick and requires no credit check. Getting the money can take just a few days, depending on the loan amount and if you have any other open 401(k) loans.

2. Easy to repay

When you contribute to a 401(k), you contribute pre-tax dollars from payroll deductions. Most plans will let you repay a 401(k) loan in a similar fashion, though your outstanding loan balance will be paid with after-tax payroll deductions. Making monthly payments towards your loan is easy and predictable.

3. Can Help Retirement Savings

A 401(k) loan comes with interest. Therefore, you end up paying back more than you borrowed, which helps with your retirement savings somewhat as you contribute more than you borrowed. Of course, taking out a 401(k) loan should still be heavily considered over other means, depending on why you're doing it.

What Happens If You Leave Your Job with an Unpaid 401(k) Loan?

If you quit your job, your 401(k) loan must be paid back in full within a short period, sometimes as little as 60 to 90 days. If you don't fulfill the repayment of your loan, it will be considered in default, and you will be taxed plus a 10% early withdrawal penalty on the remaining balance if you are under 59½.

What are Alternatives to Borrowing From Your 401(k)

Some alternatives to borrowing from your 401(k) include:

  • Using your emergency fund
  • Pick up a 0% introductory balance transfer credit card
  • Use non-retirement savings, such as a brokerage account
  • Withdraw contributions (but not earnings) from a Roth IRA 404

Wrapping It Up

Depending on your retirement plan and how long you plan to work, taking a 401(k) loan out might be right for you. If you're not sure if it's right to take the loan, consider the alternatives as well.

Have you ever taken a 401(k) loan? What did you use it for?