Should You Borrow From Your 401(k)?

by Tim on January 26, 2011

Did you know you could actually borrow from your 401(k) or 403(b) and pay it back without penalty?

The IRS permits you to take a loan from your employer sponsored retirement plan (not available for IRAs), as long as your employer’s plan allows loans. However, just because this option is available, doesn’t mean it’s a good idea. Knowing the impact of borrowing from your retirement account is important to understand before pulling the trigger.

Rules For Borrowing

The IRS generally requires you to be 59 ½ to access your retirement funds, but has made special provisions for borrowing.

  • Plan must allow loans

  • You employer is not required to allow loans from the 401(k) or 403(b) plan. If loans are allowed under the plan, you can visit your HR office to obtain the paperwork or contact information for the plan sponsor who would draw up the loan from your account.

  • Maximum Term is 5 Years

  • Most plans will allow you to customize the length of the loan from 1-5 years. Currently, IRS rules will not allow you to pay back the loan for more than 5 years.

  • Maximum Loan Amounts

  • You can borrow up to $50,000 or half the value of your account – whichever is the lesser of the two. For example: If you have $90,000 in your 401(k), you can borrow $45,000 because this is half or the balance and it is less than $50,000. If your balance was $120,000, you can borrow a maximum of $50,000.

  • Minimum Loan Amount

  • For many retirement plan, a loan minimum of $1,000 is common. Check with your plan sponsor to see what the minimums are for your specific plan.

  • Fees and Charges

  • Employer retirement plans can charge a fee to administer the loan. Generally there is a set up or initiation fee that can be from $100 – $200 and is usually added to the borrowed amount. In addition, there are sometimes annual fees for maintaining the loan, and these can vary from plan to plan.

Pros of Borrowing From Retirement Account

  • No Early Withdrawal Penalty or Taxes

  • Borrowing from your retirement account allows you to avoid the 10% penalty of withdrawing your funds before reaching 59 ½ years of age. Since the funds are still considered as a part of your retirement plan, you are not taxed on the funds you borrow.

  • Low Fees and Interest Rates

  • Most retirement plan loans will have low rates and reasonable fees compared to a personal loan at a bank or credit union. (See the Fees and Charges above)

  • Pay Yourself Interest

  • One of the nice parts of borrowing from your retirement account is that most of the interest goes right back into your account. It’s as if you are paying yourself the interest that should have been accruing. I’ve seen some plans that have interest rates of 5% but 4% goes into your account and only 1% is kept as administration fees – translating into basically a 1% loan!

Cons of Borrowing From Retirement Account

  • Contributions May Be Frozen

  • Sometimes plans will force your contributions to be stopped for the term of the loan. This makes a loan unattractive because it means your retirement account will lose momentum and it can really impact your ending balance.

  • Defaulting on Loan

  • Although defaulting on your loan doesn’t hurt your credit, it does turn the loan into taxable income. This means if you default on a $20,000 loan, you are responsible to pay taxes on the extra $20,000 now added to your income and that might just push you into a new tax bracket.

  • Cannot Make Additional Payments

  • Many retirement loan repayment plans don’t allow you to make extra payments to your loan. You can either make the payments or pay it off in full. Saving those extra payments until you can pay it off in full is a good strategy for paying it off before the term.

  • Accessing Long Term Savings is Dangerous

  • Let’s face it; Americans don’t have enough saved for retirement as it is. Tapping into your retirement account for any reason can be dangerous for your financial future, especially if your employer freezes contributions during the term of the loan.

    Borrowing from your retirement plan can be a good option if used correctly. It can also be a terrible decision if you aren’t disciplined. If you’re borrowing to pay down credit card debt, take some time to really think about the reason you’re in credit card debt in the first place. If you’re borrowing for college, I suggest considering a government loan first or to look into other saving options first.

    Have you ever borrowed from your retirement account? In your opinion, what would be a good reason to borrow?

    Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.

{ 9 comments… read them below or add one }

JoeTaxpayer January 26, 2011 at 9:46 am

This is where psychology does kick in. If you are borrowing to pay off a credit card at 18% and paying (my 401(k) charges) just 4%, this sounds like a great deal, but only if you’ve changed your ways and have a plan to not get into card debt again.
The one time I recommend it – when the borrower produces a well thought out budget, with a good plan to pay off the outstanding credit cards in short order, but the budget leaves no room for deposits to the 401(k) which would be matched. In this case, the matched funds would more than make up for the tax and penalty of withdrawal if the job is lost. e.g. $2K deposit, net $1500 out of pocket after taxes. The $4K after match would still net $2600 after tax (if still in 25% bracket) and the $400 penalty.
A bit convoluted, but I say “never miss the matched funds.”

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krantcents January 26, 2011 at 5:36 pm

No, I have a lot of choices. I would use a 401K loan only if I had no other choice.

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Gholmes January 26, 2011 at 5:37 pm

I borrowed from my 403b, and it was to buy rental property (triplex). Within a year wife left (divorce), all 3 tenants that came with the property decided to quit paying rent (3 evictions) and my “secure” position I worked I was consolidated. I did not have enough money to pay back my 403b but one good thing tax wise is that I lost so much on my rental that helped off set the tax bill on not paying my 403b. So much for me reading Rich Dad Poor Dad.

That was a period in my time that I thought I could leverage my way to to wealth. Using OPM (Other peoples money). Not anymore I am following Dave Ramseys steps and now out of debt and having success.

I would never again borrow money from my 403b or 401k. Nor would I recommend it.

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Derrik Hubbard, CFP January 26, 2011 at 8:36 pm

Good job of laying out the pros and cons, Tim.

One additional con worth mentioning is that you have to pay taxes TWICE on any money you borrow out of your 401k.

1. You generally repay the loan with after-tax money
2. You pay taxes on the funds when eventually withdrawn in retirement

Borrower beware!

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Tim @ Faith and Finance January 26, 2011 at 11:59 pm

@JoeTaxpayer – Absolutely right about the matched funds. Never want to miss those dollars. You also said it perfectly about controlling the psychological side of your spending. A loan will only hurt you if you can’t do this.

@Krantcents – I hear ya…I like to view my long term savings as just that…long long long term.

@Gholmes – Sounds like a really tough situation to work through. Really glad you were able to get back on track with Ramsey – his stuff is great! Thanks for sharing your experience with us!

@Derrik – Thanks! I’m really glad you pointed that out. I debated about putting that in there or not…it’s true though. You are paying it back with already taxed dollars…then you have to pay taxes later. I don’t like paying any more taxes than my fair share. 🙂

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retireby40 January 27, 2011 at 6:39 pm

I don’t want to borrow from our 401k at all. It’ll have to be an emergency for me to even consider it.

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Squirrelers January 27, 2011 at 9:19 pm

This was a well organized and thought out post. I hadn’t really paid too much attention to the “pro” side of things. The idea was presented to me by someone some years back and I immediately bristled at the thought of borrowing from a 401(k).

Having said this, I still wouldn’t borrow from a 401(k) unless it’s a true emergency. I’m not keen on the notion of taking money that’s specifically earmarked for retirement, and using it for anything else.

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Tim January 29, 2011 at 5:19 pm

Thanks @Squirrelers! I’m with you and @retireby40 – Borrowing from retirement funds isn’t my first choice, but I’d consider it for a really big emergency.

Thanks for your comments!

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Lisa March 26, 2011 at 6:42 pm

You just have to be cautious when borrowing against a 401k. My mother-in-law has borrowed from her 401k more times than one should. She’s now 53 with only $100k in her 401k account. I’m in my early 30’s and i tell her that if that were me I’d be freaking out right about now. Unfortunately some people live for today and forget tomorrow. I understand enjoy today but you need to find a balance. Whenever she talks about taking a vacation her first thought is to borrow from her 401k. Seriously!?

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