Borrowing from 401(k) plans: The basics, pros, cons & alternatives

When money gets tight, you may start to wonder, "Should I borrow from my 401(k)?" If you're in a financial bind, taking out a loan from your retirement account may seem like the perfect solution. However, it's important to understand the pros and cons of borrowing from 401(k) plans before proceeding. The more you know about how these loans affect your finances, the more equipped you'll be to make the right decision.

A 401(k) loan is money that you borrow against your 401(k) employer-sponsored retirement account. Most employers offer a loan feature with their 401(k) plans.

If you borrow from your 401(k), you typically have to pay yourself back, at a minimum through quarterly payments, over a five-year period. Some plans extend that period to 25 years if the money is used to purchase a primary residence. There's a big incentive to make your scheduled payments in a timely manner. Any quarterly amounts that are overdue are subject to income tax.

In addition to the principal amount you borrow, you're also charged interest. The interest rate is typically pretty competitive—often a percentage point above the prime rate. That's significantly lower than what customers usually pay on a credit card or even a personal loan. And, crucially, that interest goes into your account rather than a bank.

Depending on your specific plan, you may have to pay a small processing fee to cover the cost of the loan paperwork.

In some cases, the 401(k) plan may require your spouse's consent before allowing you to take out a 401(k) loan, so be sure to check your plan details.

Under IRS rules, you're able to borrow up to 50% of your vested balance or $50,000, whichever is less. An exception to this limit is if 50% of the vested account balance is less than $10,000. In that case, you may borrow up to $10,000.

You can take more than one loan from your 401(k), but the total outstanding balance cannot exceed these IRS limits.

Yes, you can pay off a 401(k) loan early without penalty. You may have the option of regular paycheck deductions and can specify the period of time in which you want repayment to end.

Some plans require workers to repay loans once their employment has ended. Research indicates that a staggering 86% of workers who change jobs with an outstanding 401(k) loan end up defaulting on their loans. If you're planning to take out a substantial amount of cash, that's a possibility you need to think through. Check your plan details and read the terms and conditions carefully.

Compared to other ways of accessing cash—like taking a hardship withdrawal from your 401(k) account or taking out a bank loan—borrowing from your 401(k) can have a number of advantages:

Unlike hardship withdrawals, younger workers generally don't have to worry about paying income taxes on a 401(k) loan or the harsh 10% early withdrawal penalty, assuming that you make your scheduled payments on time.

The interest assessed on 401(k) loans is low compared to other forms of borrowing. And because you pay that interest to yourself, it's helping to build your retirement balance back up again.

When you apply for a bank loan, they typically assess your creditworthiness. If your credit history is less than stellar, they can use that information to charge you a higher rate or reject your loan outright. By contrast, borrowing from your retirement account does not require running a credit report.

Usually, payment information on a traditional loan will end up on your credit reports. That means, your credit score can drop significantly if you owe a large balance or you miss any payments. Payments on your 401(k) are not reported by a lender, so they don't end up on your credit report.

The lack of a credit check beforehand certainly makes retirement plan loans a relatively easy way to access funds. But that's all the more reason to understand the potential drawbacks of these loans, too. Here are some of the factors you'll want to consider:

If the reason you're taking money from your 401(k) is because of financial hardship, a loan might seem like a convenient safety net. But unless you're confident you can repay the loan—which you typically must do within five years—you could make things worse for yourself. Any money you don't pay back on time is subject to income taxes plus the 10% penalty if you're younger than 59½.

The money you pull out of your retirement account isn't being invested, so you're missing the opportunity for that money to grow over time. Because the interest going back into your account is relatively low, it may not make up for lost returns on your stock and bond assets. Therefore, even if you're able to pay the loan back, you could end up with fewer assets in retirement.

Contributions to a traditional 401(k) don't count as taxable income. But that's not the case for the money you use to repay your loan. By borrowing, you're nullifying some of the tax advantages of these accounts. The same is true if you own a Roth 401(k), where you contribute post-tax money but have the potential for tax-free withdrawals after 59½. When you take a loan, it is withdrawn tax free, however, you are making the loan payments with post-tax dollars. So, you face double taxation on the interest as it will be taxable when you withdraw the funds in the future.

Often, the best solution to a cash crunch is to minimize your expenses so you don't need a loan. That could mean moving into a more affordable home, for example, or trading in your current car for a less pricey model. If borrowing becomes a necessity, however, 401(k) loans aren't your only option. Here are some alternative sources of funds that you may want to look at:

Loans that are backed by collateral—in this case, the equity in your home—typically offer lower interest rates than other forms of borrowing. You may be able to receive a lump sum of cash or a home equity line of credit from which you draw money as needed. Both types require you to pay closing costs on the home's value (typically 2-5%), so they make more sense for larger loan amounts.

If you don't own a home or want to pay closing costs, a personal loan from a bank or credit union is another possible route. Typically, the interest rate is based on your credit score, annual income and amount of existing debt.

Credit card issuers frequently offer a 0% introductory interest rate to entice new users. Therefore, signing up for a new card can be a good way to free up some cash in your budget. But this strategy only makes sense if you have a solid plan to pay down the card balance before the introductory period is over—typically in 15–18 months. After that, you'll start getting charged the normal rate, which tends to be much higher than other loans.

You may decide that you want to take a 401(k) withdrawal that you don't plan to pay back. However, if you take a distribution from a traditional 401(k) before age 59½, you will be charged 10% tax penalty unless you meet an IRS exception.

If you have a Roth 401(k) and your plan allows it, your contributions can be withdrawn. Since you’ve already paid taxes on these contributions, the withdrawals will be tax-free. However, you must be age 59½ if you don't want to incur the 10% tax penalty on the earnings in the account, unless you meet an IRS exception.

Remember that withdrawals from 401(k)s should be avoided before retirement, if at all possible. You will miss out on compounding interest on the dollars you withdrew and could jeopardize your retirement savings goals.