Borrowing money from a 401(k) is a common strategy used to get through hard times.
There are some perks to it, including the fact you don't need good credit to qualify and you pay interest to yourself instead of a creditor. And some Americans decide these advantages outweigh the considerable downsides, such as passing up potential investment gains on the borrowed money.
If you're in the process of deciding whether borrowing from your retirement account makes sense, here are seven things you need to know.
1. You can usually borrow up to $50,000 or 50% of your vested balance
401(k) loans are generally limited to the lesser of $50,000 or 50% of your vested balance.
However, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) has doubled the amount you can take out of your retirement accounts if you are experiencing financial hardships due to COVID-19. That means you can borrow up to $100,000 or 100% of the amount of your vested balance.
Of course, you can only borrow as much as you have available in your 401(k), and the larger limit applies only for coronavirus-related loans. The bump in the maximum borrowing amount also applies only to withdrawals made in 2020.
2. You typically have five years to repay the loan
A 401(k) loan generally must be repaid within five years of borrowing the money from your account.
However, the CARES Act temporarily extends your repayment time if you're borrowing due to COVID-19. For loans outstanding after March 27, 2020, with payments due between March 27 and the end of this year, you'll have six years to repay what you owe.
That extra year can make repayment more affordable, although it means your money will be out of the stock market for longer, so your loan could be costlier in the end due to the lost potential for investment gains.
3. Not all 401(k) plans will allow you to borrow
Not all 401(k) plans allow you to borrow against your retirement account. If your employer doesn't permit it, you won't have this option available to you.
Further, while the CARES Act allows employers to enable larger loans, it doesn't require them to do so. Even some 401(k) administrators that generally permit borrowing may not double the loan limits.
You'll need to check with your plan administrator to see if you're allowed to borrow at all and, if so, how much you can borrow.
4. If you lose your job, you may have to repay the money by tax day next year
Departing from your job used to trigger a requirement that you repay your loan within 60 days. However, the rules changed in 2018. Now, you'll have until tax day for the year you took the withdrawal to pay what you owe.
So if you borrow in 2020 and lose your job, you'll have to repay the full balance of your loan by April 15, 2021 (or Oct. 15, 2021, if you file for an extension on your taxes). The CARES Act did not change this rule.
This longer deadline does slightly reduce the risks of borrowing. But if you take out a loan now, spend the money, and then are faced with an unexpected job loss, it could be hard to repay your loan in full -- especially if you took advantage of the new larger loan limits under the CARES Act and owe a lot.
5. If you default on your 401(k) loan, you'll owe a penalty
If you do not pay your 401(k) loan back as required, the defaulted loan is considered a withdrawal or distribution and thus subject to a 10% penalty applicable to early withdrawals made before age 59 1/2. That's potentially a huge cost, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
The penalty for defaulted loans still applies to COVID-19-related loans taken under the CARES Act's special rules. This can be confusing, as the CARES Act also altered the rules for withdrawals, enabling you to take a coronavirus-related distribution from your 401(k) in 2020 without incurring the customary 10% tax penalty. Unfortunately, if you default on your 401(k) loan, it doesn't convert to a penalty-free withdrawal, even if you would have been entitled to one this year.
6. If you take a 401(k) loan, you'll pay interest to yourself
When you borrow against your 401(k), you have to pay interest on your loan. The good news is, you'll be paying that interest to yourself. Your plan administrator will determine the interest rate, which is usually based on whatever the current prime rate is.
The bad news is, you will pay interest on your 401(k) loan with after-tax dollars. When you take money out as a retiree, you are still taxed on the distributions at your ordinary income tax rate. This means the money is effectively taxed twice -- once when you earn it before using it to pay back your loan, and then again when the withdrawal is made.
The interest you pay yourself is generally also below what you would earn if you had left your money invested.
7. 401(k) withdrawals are an alternative to 401(k) loans
Under most circumstances, a 401(k) loan is preferable to a 401(k) withdrawal if you must use the funds in your retirement accounts to meet your immediate needs. A loan is a better alternative because:
- You avoid the 10% early withdrawal penalty applicable if you take money out of your 401(k) before age 59 1/2
- You'll repay the money to your 401(k) so will not permanently lose out on all of the investment gains it could've earned between the time of the withdrawal and the time you retire
However, in 2020, a 401(k) withdrawal might be a better option as the special rules established by the CARES Act enable you to avoid the early withdrawal penalty; pay taxes on withdrawn funds over three years; and repay the withdrawn amount over three years without any effect on future contributions and without owing taxes on the repaid funds.
A withdrawal thus eliminates the risk of being hit with the penalty in case of a defaulted loan, and still gives you the chance to reinvest.
Weigh the pros and cons before you take out a 401(k) loan
Always carefully consider the pros and cons before you borrow against your retirement account. And if you are deciding between a loan or withdrawal in 2020, make sure you understand the special rules under the CARES Act so you can determine which option is best.