For many American adults, building a retirement fund and paying off high-interest debt are considered to be perhaps the two most important financial goals many look to achieve before stepping out of the workforce.
However, challenging economic conditions in more recent times have not only made it harder for many people to contribute towards their retirement savings, but in return, many have started taking out loans from their traditional 401(k) plans to pay off debt and cover other financial burdens.
In a second-quarter report by Bank of America, research showed that the number of participants taking out “hardship distributions” on their 401(k) plans has increased 36 percent year-over-year. More concerning, the same report revealed that hardship distributions increased by 12 percent between the first and second quarter of the year.
Pulling money from your 401(k) retirement plan might help reduce near-term debts, but without the necessary considerations, this could potentially result in long-term financial and tax implications.
What is a 401(k) loan?
Before you can pull money from your 401(k) plan, take some time to familiarize yourself with the basics of how these loans work.
For starters, not every 401(k) plan will permit loans or hardship distributions. In some instances, employee-sponsored accounts will have limited leverage, as employers will decide whether participants are allowed to borrow against their accounts. While the opposite can also be true, be sure that your account allows hardship distributions.
Secondly, you may be allowed to borrow against your account, when you have a vested balance in your 401(k) plan. While you may be borrowing money from yourself, in this case, you will still be required to repay the loan amount over a designated time frame. Keep in mind that borrowing from your 401(k) works similarly to any other type of loan, and you will be charged interest on the borrowed amount.
Six things to know when borrowing against your 401(k)
Compared to other types of loans, a hardship distribution is simply borrowing money from yourself, and then repaying those accounts. While on paper, this might seem less complex than having to take on more debt or taking out a loan from a bank, there are some things you will need to consider before pulling money from your retirement plan.
Borrowing limits
While you may have a robust 401(k) balance, it doesn’t necessarily mean that you will be able to borrow a large sum or have access to everything before retirement.
Findings by investment firm Vanguard, indicate that the average 401(k) balance was roughly $141,542 in 2021, which represented a 10 percent increase from 2020. Multiple factors can impact how much you already have stocked away in your 401(k) account, such as your age, occupation, personal contributions, and employer contributions, among other things.
More than this, the IRS has introduced maximum allowable borrowing limits on 401(k) accounts. For 401(k) plans that allow loans, you may be able to borrow up to $10,000 or 50% of the vested account balance. However, you may not exceed the $50,000 threshold.
Let’s say, for example, that you already have $200,000 in your 401(k) account, seeing that you’re nearing retirement and have made monthly contributions throughout your life. If your account allows loans, you will not be able to borrow 50% or $100,000 from your vested balance. Instead, the most you will be able to withdraw would be $50,000.
For instances where 50% of the vested account balance is less than $10,000, you could be allowed to borrow the full amount, considering that your 401(k) plan allows loans. What’s more, while you could potentially make multiple loans on your 401(k) account, the lifetime loan amount is not permitted to exceed these borrowing limits.
Repayment terms
Unlike other loans from traditional lenders, repayment on a loan from your 401(k) plan will need to be repaid within five years from the loan date. While this might seem like more than enough time to restock your 401(k) account before retirement, failing to meet payments on time will result in late payment fees and tax penalties.
Depending on your plan, you may be scheduled for monthly or quarterly payment deductions. This would ensure that an agreed amount is deducted from your income to fulfill the loan repayment schedule.
Compared to traditional lenders, where you may have more than five years to repay the borrowed amount, taking a loan on your 401(k) account will give you limited financial leverage.
Typically people will use a 401(k) loan to pay for smaller debt, such as medical bills or even car payments. “We’ve seen people using a 401(k) loan to fix up their car, or getting it serviced before selling it, allowing them a bit of financial leverage, while limiting their risks altogether,” says Matthew Hart from Axlewise, an online automotive platform.
Instead of using these loans to pay off things such as credit cards or even a mortgage, you might need to reconsider near-term debts that may carry higher interest rates and less risk.
Financial security
Next, you need to consider how much financial security you currently have in terms of your job. Recently, there has been a lot of talk of pending payroll deductions and layoffs as companies look to stabilize their bottom-line performance.
If you’re feeling uncertain about the current state of your employment and foresee that you will need to either look for a new job in the coming months or even start at a new company, you might need to reconsider a 401(k) loan and seek other alternatives.
Historically, you had 60 days to repay your 401(k) loan after leaving your current job or employer. However, the introduction of the Tax Cuts and Jobs Act in 2018, now allows you until the following tax day, in the new tax year, to repay any borrowed amounts after leaving your job.
Let’s say you took out a loan on your 401(k) plan in 2023, you would need to repay the borrowed amount in full by April 15, 2024.
While this might allow you some leverage, in terms of how long you have until the account needs to be settled, the risk of being laid off or unexpected employment termination could result in bigger financial burdens.
Loan penalties
Depending on your 401(k) plan and whether you may be permitted to take out a loan, you may be subject to penalty fees unless you are unable to repay the borrowed amount or default on your debt agreements.
If you are unable to make loan payment requirements, the borrowed amount will be considered as a withdrawal or distribution. What this means, is that you will then become subject to a 10 percent early withdrawal penalty fee for any loans taken out before the age of 59 ½.
This is fairly common, seeing that any person who withdraws money from their 401(k) plans before the age of 59 ½ will typically be subjected to the early withdrawal penalty fee.
While you may have less risk in terms of the type of loan you may have taken out, the cost of defaulting on your repayment agreements could become a costly mistake. Instead, it would be advised to rather minimize these risks by seeking financial alternatives and leaving available funds in your 401(k) plan invested.
401(k) loan interest
As with traditional loans, you will be required to pay interest on the borrowed amount. Your plan administrator would determine the interest rate on your loan, and multiple factors can influence the interest rate on your 401(k) loan.
Keep in mind that administrators will determine the interest rate based on the current prime rate, which has increased several times over the last few years. Currently, interest rates are standing at 5.25% – 5.50% and are subject to change at any given time.
One of the small benefits that comes with borrowing against your 401(k) plan is that any interest owed will be paid back to yourself. This would mean that instead of paying interest to a lender or your plan administrator, you will be accumulating the interest in your account.
However, the downside to all of this is that interest on a 401(k) loan is effectively taxed twice. For starters, you will be required to pay interest on the loan with after-tax income.
These conditions become even more burdensome once you’ve retired. You will be subject to tax before using the account balance to repay other debts and once you have approved a withdrawal. What’s more, even as a retiree, you will be subject to ordinary income tax once the distributions have been approved by your administrator.
While there may be pros and cons to this scenario, it’s advised that repaying these loans can become an expensive exercise for retirees who are looking to be more frugal with their retirement savings once they have left the labor force.
Limited plan contributions
One of the most significant drawbacks of taking out a 401(k) loan is that you may be making fewer contributions to your savings plan than you would’ve done before borrowing against your account.
Depending on your 401(k) plan and the agreement with your administrator, you may be unable to make any direct contributions while still having an outstanding loan amount in your account. This would mean that if you spend the next three or five years repaying your loan, you would not be directly adding to your 401(k) account. This could cost you in the long run, and lower your chances of taking advantage of available 401(k) tax benefits.
What’s more, having outstanding 401(k) loans may impact any employer matching contributions. Generally speaking, employer contributions are based on physical participation in the 401(k) plan, and even though you might be repaying the 401(k) loan, this is often not recognized as an active contribution.
The short of the long story is that you may lose out on any contributions during the time it takes you to repay the borrowed amount. This would not only mean that you are stocking away less in your 401(k) retirement plan but that your account will grow slower during the repayment period.
Consider loan alternatives
While borrowing against your 401(k) plan might allow you immediate access to funds that you can use to pay for big expenses, such as hospital bills or car repairs, the near-term benefits don’t necessarily outweigh the long-term growth opportunities.
Instead, it’s advised to consider other loan alternatives instead of tapping into your 401(k) account.
Hardship withdrawal
One alternative could potentially be to consider a hardship withdrawal, which in some instances may be different compared to a hardship loan, depending on your 401(k) plan. With a hardship withdrawal, you will pay income tax on the distribution, and you may be able to qualify for an early withdrawal penalty exemption.
Home equity loan
You could also consider a home equity loan as a retiree or someone soon to be retired. If you already have equity in your home value and will not be selling your home anytime soon, you can use a home equity loan to pay for small debts or smaller maintenance on the property. Additionally, a home equity loan is often tax deductible, which could allow you more financial leverage in the near term depending on the amount borrowed.
Why take out a 401(k) loan?
You might consider borrowing against your 401(k) plan for many different reasons. Each person’s financial situation may be different and unique. In most instances, people tend to undergo a 401(k) to pay for short-term debts that carry a high-interest rate. This could range from auto loans, or personal loans, depending on the interest rate.
Another reason why people might choose to borrow against their 401(k) is that it allows them immediate access to funds that can be used to pay for outstanding bills or expenses, such as hospital bills, home repairs, or other maintenance costs.
There are multiple benefits to taking out a 401(k) loan, however, for someone who might already be approaching retirement or have less than five years left before retiring, it’s advised to seek alternative options instead of using your 401(k) account to fund other expenses.
These accounts assist with creating significant financial security during retirement and require years of active contribution to accumulate a steady return in the long run. The best option would be to leave these accounts to grow over time and seek other financial alternatives based on your needs.
Final thoughts
The drawbacks of taking out a 401(k) loan can easily outweigh the benefits, especially if you are already approaching retirement in the coming years. While this might seem attractive to pay for other debts or bills, it would be best to consult with a financial expert before borrowing against this account.
By making smarter financial choices, you will be actively contributing towards your nest egg that will help carry you throughout retirement. Instead of getting ahead of yourself and using your retirement savings to pay for current expenses, see how you can decrease any financial burdens and what options best suit your financial position.
Featured Image Credit: Photo by Andrea Piacquadio; Pexels; Thank you!
