There are pros and cons to borrowing money from your 401k plan. You can only borrow from your 401k plan if you are currently employed by the company that offers the plan, and even then, not all 401k plans allow loans, so you’ll need to check the rules on your plan to see if loans are allowed.
If you are eligible to borrow money from your 401k plan consider the pros and cons before you decide to take the loan.
Pros of Borrowing From 401k
- No loan application necessary
- No minimum credit score required
- You repay the loan with automatic paycheck deductions up to a maximum term of five years.
Cons of Borrowing From 401k
- You are now paying interest with after-tax money. If you hadn’t borrowed the money, it would be earning tax-deferred interest inside of the 401k plan.
- If you leave your employer before the loan is repaid, any outstanding balance may be treated as a taxable distribution to you unless entirely repaid within a specific amount of time.
- 401k money is protected from creditors and bankruptcy. If you borrow it out to pay debts, and remain in financial trouble and end up filing bankruptcy, you will have used money to pay debts that didn’t have to be used.
- You may pay a higher interest rate with a loan to your 401k plan
Learn more: 7 Things to Know About 401k Loans
Reasons People Borrow Money From 401ks
People borrow money from their 401k for the following reasons. I do not think they are good reasons:
- To fund a business start up
- To help a grown child
- To buy a car
- To pay off other debt
For the most part I think borrowing money from your 401k plan for these items is a bad idea.
Learn more: What to Know Before Cashing Out 401k
Alternative to Borrowing from Your 401k
Some 401k plans allow hardship withdrawals for things like unexpected medical expenses or to prevent eviction. If you take a hardship withdrawal you will pay taxes on the amount you withdraw in the year you withdraw it. See 401k Hardship Withdrawals for details on the differences between hardship withdrawals and a loan from your 401k.
Who Should Borrow Money from Their 401k Plan?
Before borrowing money from your 401k plan you should explore all other options. Since 401k plan money is protected from creditors, you want to think very carefully before you borrow it out and void that protection.
If you manage money well and feel your job is secure, a 401k loan might be an acceptable option for you. I have seen a CPA repeatedly borrow and repay money from his 401k plan to help fund the acquisition of other businesses. This worked well for him.
Learn more: How to Take Money Out of a 401k Plan
Who Should Not Borrow Money from Their 401k Plan?
If you have debt, borrowing from your 401k plan to pay it off might be the worst possible solution. Why? Because if you do not get your finances in order, and your debt troubles continue, if you leave the money in your 401k plan it is protected from creditors and from bankruptcy.
For example, assume Chris has $25,000 of credit card debt and $50,000 in his 401k plan.
He borrows $25,000 from his 401k plan to pay off his debt. He accumulates additional debt and later ends up filing bankruptcy. If had left the $25,000 in his 401k plan, it would be a protected asset and the bankruptcy court could not touch it. Since he withdrew it and paid off debt, now he not only has bankruptcy, he must continue to repay the $25,000 to his 401k plan rather than having the bankruptcy eliminate that debt.
If he had filed bankruptcy instead of borrowing the money out of his 401k plan he would come out of bankruptcy with $50,000 still in his 401k plan. After bankruptcy if he does not repay the 401k loan it will be considered a taxable distribution, and he will owe taxes on the $25,000. Tax debt cannot be eliminated by bankruptcy.
Before you borrow money from your 401k plan to pay off consumer debt, consider all options to eliminate debt, including bankruptcy. If you choose to borrow from your plan, do so only with an absolute commitment to getting and keeping your finances in order.