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[Prefer to listen? You can find a podcast version of this article here: E219: Understanding 401(k) Loans – How They Work and When to Consider One]

Sometimes you need some cash to bridge the gap during an unexpected event, and your emergency fund is not enough to cover it.

Or maybe you have a planned expenditure or life transition and need a lump sum of money to make it work.

Many people consider withdrawing money from their 401(k) plans for these events, and unfortunately, they often end up paying taxes and penalties on the withdrawal, which can diminish its usefulness and do considerable harm to their financial future.

However, there is another option: a 401(k) loan.

If you've ever wondered whether you can borrow from your 401(k), the answer is likely yes, but it comes with a host of considerations. Before you consider borrowing from your 401(k), you need to understand the mechanics of 401(k) loans, the potential downsides, and the risks involved.

What is a 401(k) Loan?

A 401(k) loan allows you to borrow against your retirement savings in your employer-sponsored 401(k) plan, subject to certain limits and conditions.

You can borrow up to the lesser of $50,000 or 50% of your vested account balance. If 50% of your balance amounts to less than $10,000, you can still borrow up to $10,000.

How to Get a 401(k) Loan

Before anything else, verify that your 401(k) plan permits loans. Not all plans do. If loans are allowed, obtain the plan's loan policy document from your HR department or plan administrator. This document outlines key details such as borrowing limits, interest rates, repayment terms, and any specific conditions or restrictions.

Next, you'll need to fill out a loan application form, which you can get from your HR department or directly from the plan administrator. This form will require details about the amount you wish to borrow and your preferred repayment schedule.

Once submitted, your application will be reviewed by your plan administrator. Approval times can vary, but it should not take too long unless there are complications or information is missing from your application.

Once everything is set up, the loan amount will be disbursed to you. Depending on your plan’s rules, this can be via direct deposit to your bank account or a check.

Note for business owners with a Solo 401(k) plan: You may also be able to take out a 401(k) loan. Check your plan documents to see if your plan allows loans. If so, you can take a 401(k) loan against your Solo 401(k). As a business owner, this can make the loan lower risk than if you were an employee (more on that later).

Repayment Terms

If your loan is approved, you’ll need to set up a repayment plan. Loan repayments are typically made through payroll deductions, with payments automatically deducted from your paycheck on a pre-agreed schedule. This ensures payments are made regularly and helps avoid default.

401(k) loans must be repaid within five years unless used for purchasing a primary residence. In that case, depending on your plan, you might have up to 25 years for repayment. Repayment typically happens via payroll deductions, making it convenient and seamless to ensure you stay on track.

Common Uses for 401(k) Loans

People consider 401(k) loans for various needs, including:

• Making a down payment on a house
• Paying off high-interest debt
• Covering medical or educational expenses
• Funding necessary home repairs
• Investing in a new business venture

Each of these scenarios might justify a 401(k) loan, but they also require a thoughtful evaluation of your financial stability and long-term goals.

Pros of 401(k) Loans

There are plenty of reasons to like 401(k) loans. Some of the advantages include:

• No Penalties: Unlike early withdrawals, taking a 401(k) loan doesn’t incur taxes or penalties.
• No Credit Checks: These loans do not require a credit check, making them accessible regardless of your credit history.
• Interest Goes to You: The interest you pay on the loan goes back into your 401(k) account, essentially paying yourself back with interest.

Cons of 401(k) Loans

While there are some good things about 401(k) loans, there are some very significant downsides:

• Risk of Default: If you fail to repay the loan, it becomes a taxable event and is also subject to a 10% penalty if under age 59½.
• Job Change Risk: If you leave your job, the full loan balance becomes due by the next tax filing deadline. If you cannot pay it back, it defaults and is subject to taxes and penalties.
• Missed Investment Growth: By borrowing your 401(k) funds, you miss out on potential investment growth and contributions, which could impact your retirement savings significantly.

Because of these downsides, 401(k) loans are far from ideal and should be considered very carefully.

Should You Take a 401(k) Loan?

Taking a 401(k) loan should not be a first-line option. Consider your ability to repay within the stipulated time, especially in the face of employment uncertainty or financial instability. Weigh the immediate need for funds against the potential long-term impact on your retirement savings.

One caveat is that the job change risk is typically not a risk for business owners. Since you are the owner, it is unlikely that you will leave your "job," which basically eliminates the default risk that usually applies to employees. Keep this in mind if you're a business owner or self-employed since it changes the dynamic of taking a 401(k) loan (although the other risks still apply).

Final Thoughts

401(k) loans can be a valuable financial tool when used appropriately and with full awareness of the implications. Before going this route, be sure to consider other options first and discuss your situation with a trusted professional to make the most informed decision.