What Is a 401(k) Loan? And How Does It Work?

More and more people seem comfortable borrowing money from their 401(k) and taking out a 401(k) loan . . . even if it means falling behind on their retirement savings.

In 2020, about one out of five people with an employer-sponsored retirement plan had an outstanding 401(k) loan balance, and the average balance of those 401(k) loans was $9,663.¹

Maybe you are looking at your retirement account’s balance and wondering if a 401(k) loan could help you cover the cost of that car repair or kitchen renovation.

Listen, we’re not going to beat around the bush: While a 401(k) loan might seem to solve some of your problems right now, it creates a whole new set of issues tomorrow and years into the future . . . and it’s just not worth the headache.

Let’s dive a little deeper into what a 401(k) loan is, how it works and why it’s always a terrible idea.

What Is a 401(k) Loan?

A 401(k) loan is an arrangement that allows you to borrow money from your employer-sponsored retirement account with the understanding that you’ll need to return that money into your 401(k) over time—plus interest.

Some folks might consider taking out a 401(k) loan as an alternative to applying for a personal loan through a bank or other lender or from taking out an early withdrawal (which would mean taxes and fees).

Since you’re technically borrowing your own money, most 401(k) loans get approved pretty easily. There are no banks or lenders involved, so nobody is going to check your credit score or credit history before allowing you to borrow from your 401(k). You’re the one taking on all the risk (and we’ll get into those risks in a second).

How Does a 401(k) Loan Work?

If you want to borrow money from your 401(k), you’ll need to apply for a 401(k) loan through your plan sponsor. Once your loan gets approved, you’ll sign a loan agreement that includes the following:

• The principal (the amount you borrowed)
• The term of the loan (how long it will take you to pay back the loan)
• The interest rate and other fees
• Any other terms that may apply

If you have an employer-sponsored retirement plan—like a 401(k), 403(b) or 457(b) plan—you can usually borrow up to 50% of your account balance, but no more than $50,000.²

When you apply for a 401(k) loan, you can decide how long the loan’s term will be, but it can’t be more than five years—that’s the longest repayment period the government allows. But do you really want to be in debt for five years?

Most plans will let you set up automatic repayments through payroll deductions, which means you’ll be seeing less money in your paycheck until the loan is paid off. Those payments—which include the principal and the interest—will keep going right into your 401(k) until the principal is paid off. And keep in mind that some companies won’t allow you to put any additional money into your 401(k) while you are repaying the loan.

Ready for some bad news? Your loan repayments will be taxed not once, but twice. Unlike traditional 401(k) contributions, which are tax-deferred, you won’t get a tax break for your loan repayments. Instead, that money gets taxed before it goes into your 401(k) and then you’ll pay taxes again when you take the money out in retirement. 

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But the really scary part about taking out a 401(k) loan is what happens if you lose your job. Because if you get fired, laid off or decide to leave your job and you still have a loan balance, you’ll have to repay the entire balance back into your 401(k) by the following year’s tax filing deadline (aka Tax Day).³ Back in the old days, you had just 60 to 90 days to repay the entire balance, but the Tax Cuts and Jobs Act gave borrowers a little more time.    

If you don’t pay back the balance in time, your loan will be in “default” and the remaining balance will be treated like an early withdrawal. That means you’ll owe income taxes on whatever is left and you’ll have to pay a 10% withdrawal penalty (if you’re under age 59 1/2).

When you take out a 401(k) loan, you’re not only putting your nest egg and retirement dreams at risk—you’re also opening yourself up to some real financial pain in the present. It’s a really bad idea, you guys. 

What Is the Difference Between a 401(k) Loan and a 401(k) Withdrawal?

The biggest difference between a 401(k) loan and a 401(k) withdrawal comes down to taxes.

When you withdraw money from your 401(k), that money will be treated like ordinary income. That means you’ll have to pay taxes on that money now (along with a hefty early withdrawal penalty). You’re not obligated to put the money you took out back into your 401(k)—it’s yours to do whatever you want with it.

Note: Sometimes, you could qualify for a hardship withdrawal, which would allow you to take money out of your 401(k) without an early withdrawal penalty under special circumstances (you still have to pay income taxes, though).   

With a 401(k) loan, you’re just borrowing the money from your own account. Like any other loan, you have to pay that money back—in this case, back into your 401(k)—over a certain period of time, plus interest (which goes into your 401(k) too). Since the money you borrow isn’t treated like ordinary income, you won’t owe any taxes or have to pay an early withdrawal penalty.

But, like we mentioned earlier, that all changes if you leave your job for whatever reason. If you don’t repay the balance on your 401(k) loan by the time your tax return is due, your loan will be in “default” and Uncle Sam will be sending you a tax bill.

Why a 401(k) Loan Is a Really Bad Idea  

While borrowing from your 401(k) might sound appealing if you’re in a pinch, you’ll find that a 401(k) loan is not a lifeline—it’s a trap that could wreck your financial future.

Here are three huge reasons why you should never consider a 401(k) loan:

1. You put your retirement savings at risk.

There are many reasons folks end up taking out a 401(k) loan, from covering the cost of an emergency to wiping out credit card debt. According to the Ramsey Solutions 2021 Q1 State of Personal Finance study, more than half (57%) of those who borrowed money from a 401(k) in the past year said they did so to cover basic necessities.  

But here’s the deal: Your 401(k) is for retirement, not for emergencies, getting rid of debt or going on vacation. When you turn to your 401(k) for help now, you’re putting your retirement future at risk.

Borrowing as little as $10,000 from your 401(k) when you’re 25 years old, for example, could set your retirement back several years and cost you hundreds of thousands of dollars in your nest egg down the line—maybe more.  

In fact, a whopping 7 out of 10 people who borrowed money from their account in the past year because of COVID-19 said they regretted that decision.⁴ On top of that, more than half of Americans (56%) now feel they are behind on their retirement goals.⁵  

2. You become too dependent on your employer.

Remember: If you leave your job for whatever reason, you have until next year’s tax filing deadline to pay back the entire balance of your 401(k) loan. That means when you take out a 401(k) loan, you’re all of a sudden very dependent on your job and your paycheck to pay back that loan.

Many people choose to repay their 401(k) loans over the course of five years. Meanwhile, many workers say they’ve been at their jobs less than five years.⁶ Do you see the problem here? You might be happy at your job now, but what about a year from now? Or two years from now?

Here’s the bottom line: Debt limits your ability to choose. And a 401(k) loan can leave you feeling tied financially to your job . . . even if you desperately want to leave or have an exciting job opportunity in front of you. Don’t give your boss that kind of power over you.

3. You end up paying taxes on your loan repayments—twice.

Normally, contributing to your 401(k) comes with some great tax benefits. If you have a traditional 401(k), for example, your contributions are tax-deferred—which means you’ll pay less in taxes now (but you’ll pay taxes when you take that money out in retirement). A Roth 401(k) is the opposite: You pay taxes on the money you put in now so you can enjoy tax-free growth and withdrawals later.

Your 401(k) loan repayments, on the other hand, get no special tax treatment. In fact, you’ll be taxed not once, but twice on those payments. First, the loan repayments are made with after-tax dollars (that means the money going in has already been taxed). And then you’ll pay taxes on that money again when you make withdrawals in retirement.

What’s worse than getting taxed by Uncle Sam? Getting taxed twice by Uncle Sam.

How to Avoid Taking Out a 401(k) Loan

If you’re considering a 401(k) loan, hear this: There are always other options available to you. Here are some ways you can avoid borrowing money from your 401(k):

1. Cover the Four Walls.

If you find yourself in an emergency situation, it’s time to get into survival mode. The first thing you need to do is focus on taking care of what we call the Four Walls—food, utilities, shelter and transportation—until you can get back on your feet.

Your goal is to make sure food’s on the table, a roof’s over your head, and the lights and water keep running. After that, it’s time to take a really hard look at your budget to determine what is a “want” and what is a “need.”

2. Look for creative ways to save.

Before you even think about raiding your 401(k), you should take a good, hard look at your budget. The truth is there might be hundreds—or even thousands—of dollars’ worth of savings hiding right there in plain sight. You just have to know where to look! 

Here are some things you can do today to save some money and free up cash:

• Cancel automatic subscriptions and memberships.
• Pause contributions to your 401(k).
• Pack your own lunches (and avoid eating out).
• Check your insurance rates and shop around.

3. Get a side hustle.

Like Dave Ramsey says, “There’s a great place to go when you’re broke—to work!” Taking on a side hustle for a little while could give your income a boost to help you cover basic necessities without sabotaging your retirement savings.

From driving nights and weekends for Uber to selling your old baseball card collection on eBay, there are dozens of ways you can make some extra money right now so that you can avoid borrowing money from your 401(k).

4. Walk the Baby Steps.

Dave Ramsey’s Baby Steps have helped millions of people save for emergencies, pay off debt once and for all, and build wealth—and they can work for you too!

The first three Baby Steps can help you build a foundation for your money that is so strong, the thought of taking out a 401(k) loan will never even have to cross your mind:

• Baby Step 1: Save $1,000 for your starter emergency fund.
• Baby Step 2: Pay off all your debt (except the house) using the debt snowball.
• Baby Step 3: Save 3–6 months of expenses in a fully funded emergency fund.

When you’re completely out of debt and have an emergency fund in place, it can turn an emergency into nothing more than an inconvenience! Not only that, but it can also protect you from making a mistake that could put your retirement future at risk. That’s a win-win!   

Talk With a Financial Advisor

Still have questions about your 401(k) and what a 401(k) loan would mean for your financial future? The best thing you can do is talk to a qualified financial advisor you can trust.

Our SmartVestor program can connect you with a financial advisor you can turn to for sound advice. That way, you don’t have to make these huge financial decisions on your own.

Find your SmartVestor Pro today!

This article provides general guidelines about investing topics. Your situation may be unique. To discuss a plan for your situation, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.