A 401(k) loan might seem like an attractive option when you’re in need of funds. But it comes with several pitfalls and potential drawbacks that you should be aware of before making this decision.
What is a 401(k) Loan?
A 401(k) loan allows individuals to borrow money from their own 401(k) retirement savings account. This option is offered by many employers as part of their 401(k) plans. It is designed to provide participants with access to funds for various financial needs, such as emergencies, major purchases, or debt consolidation.
It’s important to note that not all 401(k) plans offer the option of taking loans. So, check with your plan administrator to see if this option is available to you.
See IRS – Retirement Plan Loans for additional details.
Pros of a 401(k) Loan:
There are some advantages of 401(k) loans vs. other financing options.
Easy Access:
Borrowing from your 401(k) is generally straightforward, requiring less paperwork and approval compared to traditional loans from financial institutions.
No Credit Check or Loan Qualification:
Since the loan is secured by your own funds, there’s usually no credit check involved, making it accessible to individuals with lower credit scores. You don’t need to qualify for a 401(k) loan based on income, credit history, or other factors typically considered by lenders.
Use for Any Purpose:
Unlike some other loans that might have specific usage requirements, 401(k) loans can be used for various purposes, such as emergencies, debt consolidation, or major expenses.
Pitfalls of 401(k) Loans
Although a loan from your 401(k) might seem an easy and attractive source of funds, it can have a significant impact on your retirement readiness.
Some of the disadvantages include:
Reduced Retirement Savings:
When you take a 401(k) loan, the borrowed amount is no longer invested and working for your retirement. This can significantly impact the growth potential of your retirement savings over time. Even if you pay back the loan with interest, you miss out on potential investment gains during the loan period.
Loan Limits and Repayment Terms:
401(k) loans are subject to limits imposed by the IRS, which restrict the amount you can borrow. Additionally, loans usually need to be repaid within a relatively short period, often five years. If you leave your job before repaying the loan, the outstanding balance might be due immediately, potentially causing financial strain.
Loss of Compound Interest:
Compound interest is a powerful force in growing your retirement savings. When you take a loan and miss out on contributions and growth during the loan period, you’re losing out on the compounding effect that can significantly boost your retirement nest egg over time.
Job Loss or Change:
If you leave your job, whether voluntarily or involuntarily, the outstanding balance of your 401(k) loan might become due within a short period, often 60 days. If you can’t repay the loan in time, it might be treated as an early withdrawal, subject to income tax and potentially early withdrawal penalties.
Penalties for Default:
If you’re unable to repay the loan according to the terms, it might be considered a default. This can result in income tax on the outstanding amount, and if you’re under 59½, you might also incur an additional 10% early withdrawal penalty.
Lost Contributions:
Many employers match a portion of your 401(k) contributions. While you’re repaying the loan, you might not be contributing to your 401(k), potentially missing out on employer matches that could significantly boost your retirement savings.
Stifled Financial Progress:
While it might seem convenient to access a loan from your 401(k), it’s essential to evaluate other options first. Taking a loan might mask underlying financial issues and hinder your progress in building a stable financial foundation.
Psychological Impact:
Borrowing from your 401(k) might lead to a mindset that your retirement savings are available for borrowing whenever you need funds. This can undermine the discipline needed for long-term retirement planning.
Tech Company 401(k) Loan Example
Most large employers allow 401(k) plan loans for active employees. Here are a few examples of how large technology companies describe their 401(k) loan programs:
Amazon 401(k) participant loans:
“Participants may borrow from their fund accounts a minimum of $1 up to a maximum amount equal to the lesser of 50% of their vested account balance or $50 (less the highest outstanding loan balance in the prior year). Loan terms range from one to five years, or up to 15 years for the purchase of a primary residence. All loans will bear interest at a commercially reasonable rate determined by the plan administrator and are secured by the participant’s vested account balance. Participant loans are treated as notes receivable to participants’ accounts. Principal and interest can be repaid by participants ratably through payroll deductions or as a lump sum for the outstanding loan balance. Partial repayments of the outstanding loan balance are permitted.”
Microsoft 401(k) participant loans:
“Participant loans are available in $100 increments ranging from $1,000 to $50,000. The maximum loan amount is the lesser of (a) 50 percent of the vested account balance, reduced by the current outstanding balance of all other loans from the Plan; or (b) $50,000, reduced by…Participants are limited to two loans – one Primary Residence Loan and one General Loan. The term of a Primary Residence Loan may not exceed 15 years (or 30 years for certain acquired legacy loans) or be less than 12 months. The term of a General Loan may not exceed five years (or 15 years for certain acquired legacy loans) or be less than 12 months.
The interest rate for participant loans is 1 percent plus the prime rate on corporate loans…Loan repayments are made through after-tax payroll deductions. Terminated employees generally have 60 days to elect to continue to make loan repayments or pay off the loan in full. Failure of the terminated employee to establish a loan repayment service or payoff the loan in full during this 60-day window generally results in a default of the loan, which is taxable income to the participant, with a possible 10 percent early withdrawal penalty.
Terminated employees who roll over their Plan account…during this 60-day window may avoid such taxable income and 10 percent early withdrawal penalty if they pay off the outstanding loan balance…”
Google 401(k) participant loans:
“The Plan allows participants to borrow not less than $1,000 and up to the lesser of $50,000 or 50% of their account balance. The notes receivable are secured by the participant’s balance. Such notes receivable bear interest at the available market financing rates and must be repaid to the Plan within a five-year period, unless the proceeds are used for the purchase of a principal residence in which case the maximum repayment period may be longer. The specific terms and conditions of such notes receivable are established by the Committee. Outstanding notes receivable at December 31, 2021, carry interest rates of 4.25% to 6.50%.”
Apple 401(k) participant loans:
“The Plan allows participants to borrow not less than $1,000 and up to the lesser of $50,000 or 50% of their account balance. The notes receivable are secured by the participant’s balance. Such notes receivable bear interest equal to the prime rate as reported by the Federal Reserve as of the last business day of the prior month plus 1%, and must be repaid to the Plan within a four-year period, unless the proceeds are used for the purchase of a principal residence in which case the maximum repayment period may not exceed 15 years. General purpose loans can be repaid within a five-year period. The specific terms and conditions of such notes receivable are established by the Plan’s Loan Policy.”
IBM 401(k) participant loans:
“Participants may borrow up to one-half of the value of their account balance, not to exceed $50,000, within a twelve month period. Loans will be granted in $1 increments subject to a minimum loan amount of $500. Participants are limited to two simultaneous outstanding Plan loans. Repayment of a loan is made through semi-monthly payroll deductions. Loans originated under the Plan have a repayment term of one to four years for a general purpose loan or one to ten years for a primary residence loan…
The loans originated under the Plan bear a fixed rate of interest, set quarterly, for the term of the loan, determined by the Plan administrator to be 1.25 points above the prime rate. The interest is credited to the participant’s account as the semi-monthly repayments of principal and interest are made. Interest rates on outstanding loans at December 31, 2021 and 2020 ranged from 3.25 percent to 10.75 percent. Participants may prepay all or portion of the entire remaining loan principal at any time. Employees on an approved leave of absence may elect to make scheduled loan payments directly to the Plan. Participants may continue to contribute to the Plan while having an outstanding loan. A loan default is a taxable event to the participant and will be reported as such in the year of the loan default.
Participants who retire or separate from IBM and have outstanding Plan loans may make loan repayments via Automated Clearing House (ACH) deductions to continue monthly loan repayments according to their original amortization schedule.”
401(k) Plan Loans Conclusion
In summary, while a 401(k) loan might offer a short-term solution to financial needs, it comes with significant long-term consequences. Before considering a 401(k) loan, explore other options such as building an emergency fund, seeking a personal loan, or tapping into other sources of funds that won’t compromise your retirement savings and future financial security.
