14 Must-Know Facts About 401(k) Loans (Plus When It’s Safe To Use Them)

A 401(k) loan can seem like a quick and easy way to access money, especially when unexpected expenses pop up. But borrowing from your retirement savings comes with risks, so it's important to weigh the pros and cons carefully.

If you are trying to get ahead financially, it's essential to know how a 401(k) loan can impact your future efforts to build wealth, especially for retirement.

Here are some things to know about 401(k) loans so you can make the best decision for your financial situation.

A 401(k) loan allows you to borrow money from your retirement account, which you then repay with interest. This option is available to many 401(k) plan participants, but not all plans offer loans.

There are specific rules about how much you can borrow and how quickly you must pay it back. For example, you might be allowed to borrow up to 50% of your vested balance, or $50,000, whichever is lower.

The loan must be repaid within a specified period, such as five years.

While borrowing from your retirement account isn't always ideal, there are some benefits to using a 401(k) loan. Let's explore a few of the key advantages.

Taking an early withdrawal from your 401(k) can result in hefty penalties and taxes. With a 401(k) loan, you avoid these costs as long as you repay the loan within the specified time frame.

This makes a loan a more attractive option than simply withdrawing funds, especially if you need the money in the short term and can't afford the costs that come with early withdrawals.

The interest rate on a 401(k) loan is usually lower than what you would pay for a personal loan or a credit card advance.

Most 401(k) loans charge a fixed interest rate, often around 1 to 2 percentage points above the prime rate. That's significantly lower than what you would pay with other forms of borrowing. This can make a 401(k) loan a cheaper option if you need access to cash.

With traditional loans, lenders assess your creditworthiness. When you borrow from your 401(k), your credit score isn't a factor and there is no need for a credit check.

This means you won't need to worry about damaging your credit score. And even if you have poor credit, you can still qualify for a loan from your retirement savings.

Another unique feature of 401(k) loans is that the interest you pay on the loan goes back into your account, not to a bank or lender. Essentially, you are paying yourself interest, which can help offset some of the lost investment growth during the loan period.

While this doesn't fully replace the potential gains you might have earned from keeping the funds invested, it's better than paying interest to an outside lender.

As with any financial decision, there are downsides to borrowing from a 401(k). Here are some of the potential drawbacks you should consider.

While many employers allow 401(k) loans, not all plans offer this option. If your plan doesn't allow loans, you won't be able to borrow from your account.

It's important to check with your plan administrator to see if loans are available before considering this route.

When you borrow from your 401(k), you are essentially taking money out of your retirement investments. During the loan period, that money isn't growing, and you could miss out on potential market gains.

If you are unable to replace the funds quickly, borrowing from your 401(k) could be a setback for your long-term retirement planning.

Generally, there are strict limits on how much you can borrow via a 401(k) loan. If you need more money than what your 401(k) allows, you may have to explore other borrowing options.

If you leave your job while you have an outstanding 401(k) loan, you will likely have to repay the balance within a short period.

It's important to note that federal rules require the outstanding balance be paid by your tax return due date for the tax year you separated from your employer.

If you fail to repay your 401(k) loan, it will be considered a distribution. This means you are required to pay income taxes on the amount. If you are under the age of 59 1/2, you could also face a 10% early withdrawal penalty.

These costs can significantly increase the expense of borrowing from your 401(k) if you are unable to repay the loan on time.

A 401(k) loan might make sense if you are facing a short-term financial emergency and have no other low-cost borrowing options.

For example, a 401(k) loan could provide a solution if you need to pay for medical expenses or home repairs or hope to eliminate high-interest debt. Or, perhaps, you need funds to make a down payment on a home.

However, it's crucial to have a plan in place to repay the loan quickly to avoid hurting your retirement savings.

Before you make money moves, such as borrowing from your 401(k), understand the risks.

This type of loan can provide a temporary financial lifeline, but it is important to understand the terms and potential consequences of your retirement savings efforts.

If you are unsure whether such a loan is right for you, consider speaking with a financial advisor who can highlight the pros and cons of such a move.