Should You Take a Loan From Your 401K?

We recently looked at taking Coronavirus-Related Distributions from your retirement accounts. Before pursuing that solution to your short-term cash flow needs, there may another alternative, and that is a loan from your employer-sponsored retirement plan (401(k), 403(b), etc.). Note: This does not apply to IRAs!

First, some things to consider…

Before diving in, I just want to make a quick point that dipping into your retirement accounts—whether it be a 401(k) or an IRA, a loan or a distribution—should be considered a last resort. You should evaluate all other options before going down that road. Take a look at your emergency fund, reduce all of your non-essential expenses, and maybe even consider a home equity line-of-credit. I think these are all things to consider before dipping into your retirement account. But we are in a pretty unique situation with this pandemic where a lot of people don't have any other options. So if you're in that situation, then a loan may be right for you. So let's dive in.

How much can I take in a loan?

Your retirement plan with your employer MAY allow you to take a loan from your account balance. Your company is not required to allow for this, so you're going to need to check with them or look in your plan documents to see if this option is available to you. But typically, you can take up to 50% of your vested account balance, or $10,000, whichever is greater, up to a maximum of $50,000. So let's say your vested account balance was $60,000—you could take up to $30,000 out as a loan.

With the CARES Act, these amounts have been slightly modified. For 2020, you can take up to a hundred percent of your vested account balance up to a maximum of $100,000. Back to the example, if you had $60,000 in your vested account balance, you could take that whole amount out as a loan. Also, under the CARES Act, any payments on that loan that would typically be due in 2020, you can defer those for up to a year.

What are the terms of the loan?

The terms of the loan are somewhat dependent on the plan, but typically you have 5 years to pay back that loan. There are some exceptions, but that's the general rule. You also have to pay interest on the loan, but any interest you pay just goes back into your account, so you're essentially paying yourself back.

Loan vs. Distribution

One of the benefits of taking a loan versus a distribution is that there are no taxes and penalties on a loan. However, if you don't pay back the loan, then it would be considered a distribution and you'll have to pay taxes and potentially penalties on it. But even with a distribution under the CARES Act, while the penalties have been relaxed for 2020, you still have to pay taxes on those.

I think one of the biggest advantages of a loan versus a distribution is the requirement to pay it back. Where with the distribution, there's no obligation to pay it back—under the CARES Act, you have three years to pay it back, but typically that's not the case. With a loan, you're required to pay that back so behaviorally you're more likely to put that money back into the account (which will be better in the long-run for your retirement needs).

A couple more things to consider before taking a loan: If you leave your employer before paying it back, you may be required to pay it back in a very short period of time. Otherwise, it could be considered a distribution and you would therefore have to pay taxes and potentially penalties on it. Also, with a loan, you're paying that money back with after-tax dollars. Not only are you replenishing the account with money that's already been taxed, but when you take that money out at retirement, you're going to get taxed on it again. So there's some double taxation there.

And finally, anytime you take money out of a retirement account, whether it be 401(k) or an IRA, you miss out on that growth potential on the amount that you took out. The more you take out and the longer you keep it out, the more you're missing out on those earnings, and the more you're going to have to contribute back to the account to make up for the lost earnings. That's not to say that a loan or a distribution is necessarily a bad idea; the CARES Act expanded on these because people need it. And there are a lot of people in a unique situation where they really don't have another option. If that's the case for you, talk with your advisor and see if a loan or a distribution is right for you.