The Pros and Cons of 401(k) Loans and Borrowing Against a Plan
Borrowing against a 401(k) plan can be a simple and cost effective way to get a loan. This solution, however, may not suit everyone and there are advantages and disadvantages that should be considered first. What are the pros and cons of 401(k) loans?
The Advantages of 401(k) Loans
A 401(k) loan involves borrowing against cash that the plan participant already “owns” (i.e. savings in a retirement account). This gives this type of borrowing some advantages over regular lending. For example:
- Loans can be given quickly without a lengthy application or approval process (as long as they meet relevant criteria).
- There is no credit checking process and borrowing will not affect a credit score/report.
- The interest charged is generally lower than that given to a regular loan and it is repaid into the 401(k) together with the capital borrowed.
- No tax will be payable unless borrowing/repayment criteria are not met.
- There may be no limitations of how the loan money is used.
It is also important to consider the downsides of 401(k) loans. Getting a balanced picture of both the pros and cons can help decide if this is a good move to make.
The Disadvantages of 401(k) Loans
Although using your own savings instead of taking out a regular loan may seem a good deal, there are downsides to a 401(k) loan. For example:
- Borrowing could reduce overall savings for retirement, especially if plans are used regularly for fast cash access and/or are not paid off in a timely manner.
- Repayments are made with after-tax dollars.
- Not paying back the loan to schedule/before the first distribution is made could see it categorized as an early withdrawal adding liability to income tax and a 10% penalty.
- Repayment schedules may be altered following job loss/change.
- Employers may set criteria that dictate what the money can be used for and may put new contributions on hold until the loan is paid off.
Borrowing against a plan may be a good solution in certain circumstances. Using retirement savings as a regular source of funds, however, may not be such a good idea. This could affect the overall investment over time, leaving less money for later life. Taking time to learn more about 401(k) loan rules is also important.
Is a Hardship Distribution the Same as a 401(k) Loan?
Some plans will allow hardship withdrawals as well as loans. This involves actually taking money out of 401(k)s rather than borrowing against them. There are specific criteria that need to be met to do this and this solution, once again, needs careful consideration as it will reduce retirement savings.