What You Need to Know About Borrowing from Your 401K

Are you considering to borrow against your 401k?

As your 401k account grows, it can be tempting to tap into it, especially if you’re in need of extra cash. But, considering that it’s a means to fund your retirement, it’s important to understand the pros and cons of borrowing from your 401k.

Below we’ll take a look at what happens when you borrow from your 401k, what alternatives there are and when you should consider tapping into it. Before making any decisions, you may want to consult with a financial advisor to make sure it’s the best fit for your situation.

How Does a 401K Work?

A 401k is an employer-sponsored savings plan that allows workers to set aside a portion of their paycheck for retirement. Many employers offer a matching contribution as a part of your employment benefits package, meaning that they’ll match your contribution dollar-for-dollar up to a certain percentage. The plan allows for the employee and the employer to get a tax deduction when they contribute to the employee’s 401k.

The contribution you make to your 401k will be deducted from your salary on a pre-tax basis, therefore lowering how much you pay on your income taxes.

The purpose of contributing towards a 401k is to save for your retirement throughout your years of employment, so that once you reach retirement age, you’ll have it as a resource to help finance the rest of your life.

How Much Can You Borrow From Your 401k?

While you’re in control of the contributions you make towards your 401k (up to the annual limits), there are penalties for taking out your investments prior to when you reach retirement age. The maximum amount that the Internal Revenue Service (IRS) allows you to take from your 401k is (1) 50% of your vested account balance, or (2) $50,000, whichever is smaller.

What Happens if You Borrow From Your 401K?

It may seem less risky to borrow from yourself, but once you look deeper into the drawbacks, you might think twice about borrowing from your 401k. Why?

You lose out on growth potential. You could lose out on the years of growth you’d see from when your money is invested in the market. For instance, if you take out $20,000 today, you could be losing out on more than eight times that when you retire depending on the fate of the market once you reach retirement age.

You pay interest. Although the interest goes back into your own account, you pay after-tax dollars to pay for it, meaning that the government takes from it twice — the income tax you pay on it and when you use it during retirement.

You’re at risk to the payback timeline. If you leave or are terminated from your job, you have to pay back the loan that you borrowed within 60 days or you’ll be subject to a possible penalty.

You risk having inadequate funds in retirement. If you pull money out of your 401k, you risk having less saved once you reach retirement age. Consider what your bills might be as a senior — will you have enough saved to pay for rent, utilities, debt, medical bills, and more for 30+ years?

Alternatives to Borrowing From Your 401K

There are a number of alternatives to consider before deciding to borrow from your 401k including:

Home equity lines of credit. Homeowners have the option to take out home equity lines of credit (HELOC) from their property, which allows you to cover an emergency or an expense on your home. If you have good to excellent credit, it might be a better option than borrowing from your 401k.

Taking out a personal loan. If you’re in an emergency situation where you need cash, you may want to consider personal loans before tapping into your 401k. They’re known for high interest rates and the lender may require a high credit score, but they can be worthwhile considering the drawbacks from borrowing from your 401k.

Negotiating a payment plan. If you’re unable to meet your debt payments, you may be able to negotiate a new payment plan, but note that it might have a negative impact on your credit score. Go over your income and expenses to figure out what you can afford, and then discuss a realistic payment plan with your lender.

When to Consider Borrowing from Your 401K

If you’ve looked through the alternatives and are still unsure whether or not you should borrow from your 401k, run through the following reasons why you may want to consider it.

1. It’s Your Only Option to Pay Off High-Interest Debt

If you’ve exhausted every alternative to paying off your debt, including negotiating a lower interest rate and refinance options, then you may need to turn to taking out a loan from your 401k. But, it’s recommended to think of this as a one-time, final option. Once you pay your 401k back, work towards growing an emergency savings fund to avoid taking from your 401k again.

2. You’re Borrowing to Invest in Yourself

If it’s your only option, you might want to consider tapping into your 401k if it’s to make a smart investment. For instance, if it’s to pay for education, you’ll potentially earn more money throughout your career with a higher degree, ultimately allowing you to contribute more towards your retirement.

3. You Feel Secure in Your Job

Although it’s not recommended to borrow from your 401k just because you feel secure in your job, you’ll want to feel confident that you’ll keep your job for a while if you’re going to borrow from your 401k. As mentioned before, that’s because you’ll need to pay back your loan within 60 days if you’re terminated or leave your current job.

Whether you’re seeking emergency funds or are interested in making an investment, it’s important to consider how borrowing from your 401k will affect your financial position once you reach retirement.