401(k) Loan vs. Personal Loan: What's the Safer Choice?

If you need money and have been toying with the idea of taking out a personal loan, you're probably not alone. U.S. personal loan balances reached $222 billion by the end of 2022, according to data from TransUnion, so clearly, they're a popular borrowing choice.

But what if you happen to have money socked away in a retirement savings plan? While you generally cannot take a loan from your IRA, some 401(k) plans do allow you to borrow against your balance.

But is that a smart choice? Or are you better off taking out a personal loan?

The danger of 401(k) loans

When you take out a personal loan, you're going to end up getting charged some amount of interest that your lender will make money on. When you take out a 401(k) loan, any money you're forced to repay is money that goes back into your personal account. And you might prefer to pay yourself back than pay a lender back.

But while a 401(k) loan might seem like a great solution when you need to borrow money, there are certain pitfalls you might encounter. First of all, if you don't repay your 401(k) loan on time, it will be considered a withdrawal from your retirement plan instead. That could prove very problematic if you're not yet 59 1/2 years old. Withdrawing money from a 401(k) plan prior to that age generally means facing a 10% penalty on the sum you remove.

Also, if you have your money in a traditional 401(k) and your loan ends up getting treated as a withdrawal because you don't pay it back in time, you'll face taxes on your withdrawal. This isn't a penalty -- it's the same taxes that would apply during retirement. But it's another financial hit nonetheless.

Plus, if you don't repay your 401(k) loan as you're supposed to, you'll leave yourself with that much less money in your account for retirement -- the period of life that money is supposed to be earmarked for. That could mean struggling financially once your career comes to an end.

Repaying a 401(k) loan may be tougher than you think

Clearly, there are consequences to not repaying a 401(k) loan. Now, you may be thinking, "Well, that won't be a problem, because I'll make sure to pay that loan back."

But what you may not realize is that if you leave the company sponsoring your 401(k), your repayment window might shrink to as little as 90 days. And that scenario might occur even if you're terminated due to no fault of your own, such as if your employer decides to downsize and your job lands on the chopping block.

That's why a better bet may be to take out a personal loan, even if that means having to repay a lender and losing money to interest. If you have a great credit score, you might manage to qualify for a relatively competitive rate on a personal loan. And while there can certainly be negative consequences to falling behind on personal loan payments, like massive credit score damage, you won't necessarily face the same level of penalties as you might for falling behind on a 401(k) loan.