Borrowing From Your 401(k)—Things You Should Know

For many people, the savings in their 401(k) plan is one of their largest financial assets, and many plans allow participants to borrow from it. This can be an attractive option in times of financial need. Taking a loan from your 401(k) may seem like a smart move—the interest rates are often lower than those of personal loans or credit cards, and you’re paying yourself back. However, that’s not the full picture. It is important to understand the hidden costs, risks, and alternatives. 

The Pros and Cons of a 401(k) Loan

Pros:

1. Lower Interest Rates – The interest on a 401(k) loan is typically lower than what you’d get from a personal loan or credit card. According to Experian1 the average interest rate on a 401(k) loan is over 2% lower than a personal loan.

2. Repaying Yourself – Unlike other loans, the interest you pay on a 401(k) loan is paid to yourself.

3. No Impact on Your Credit Score – Since you’re borrowing from your own savings, there’s no need for a credit check, and it won’t show up on your credit report.

Cons:

1. After-Tax Repayment – While borrowing from your 401(k) may seem easy, you repay the loan with after-tax dollars. This means you’re taxed twice—once when you earn the money to repay the loan, and again when you withdraw it in retirement. This effectively raises the cost of the loan by your tax rate.

2. Opportunity Cost – The money you take out of your 401(k) is no longer invested in the market, which could mean missing out on potential growth. Over time, this lost growth can significantly impact your retirement savings.

3. Risk of Job Loss – If you lose your job or decide to leave your employer, the loan typically has to be repaid in full. If you can’t repay, the outstanding balance is treated as a taxable distribution, subject to income taxes and a 10% early withdrawal penalty if you're under 59 ½.

How Does a 401(k) Loan Impact You?

Suppose we have a hypothetical borrower who needs $10,000 and has two options: a 401(k) loan or a personal loan. He is in a 22% tax bracket and chooses the longest repayment period allowed of five years.

401(k) Loan

• Loan Amount: $10,000

• Interest Rate: 9.5%*

• Monthly Payment: $210

• Total Repayment: $12,601

• Total Pre-tax Pay Needed: $16,155

The loan may appear to have a reasonable rate of interest, but the after-tax repayment increases the cost of the loan. In the 22% tax bracket, our borrower needs to earn $1.28 for every dollar he wants to repay.

There’s an old quote attributed to Ben Franklin that says, “a penny saved is a penny earned.” This isn’t entirely accurate, because a penny saved is much more valuable than a penny earned.

With the 401(k) loan, our borrower ends up paying $3,554 in taxes!

Is a 401(k) Loan Right for You?

Deciding whether to take a loan from your 401(k) requires understanding both your financial goals and the urgency of your needs. If you're facing a short-term emergency, a 401(k) loan may offer a solution. However, it’s crucial to understand the long-term consequences, such as missed market growth, double taxation, and the risk of being unable to repay the loan if your employment situation changes.

Making Informed Choices About 401(k) Loans

A 401(k) loan can seem like a lifeline in tough financial times, but it’s important to consider both the short-term and long-term costs. Before borrowing from your retirement savings, consider whether other options, like personal loans or adjusting your budget, might better suit your financial needs. Ultimately, a 401(k) loan should be used sparingly, and for emergencies only.

As with any financial decision, consider your unique circumstances, and consult with a financial professional to weigh your options. Borrowing from your future self might solve a problem today, but it can leave a lasting impact on your financial future.

If you’d like to learn more about borrowing from your 401(k) and what that could look like for you, we’re here to help—schedule a meeting with one of our RetireAdvisers℠ consultants today.

*Interest rates subject to fluctuation with the prime rate.

The concepts expressed herein represent the views and opinions of Pension Consultants, Inc., and are not intended as legal, tax, or investment advice for any specific individual, account, or plan.

Source:

Experian, “401(k) Loan vs. Personal Loan: How to Choose,” 2024. https://www.experian.com/blogs/ask-experian/401k-loan-vs-personal-loan/