Should You Raid Your 401(k)? Know the Pros and Cons

If you have a workplace retirement plan, such as a 401(k) or 403(b), there may be times you get tempted to make an early withdrawal before 59.5, the official retirement age. Before you crack open your nest egg, it’s critical to understand your early withdrawal options and their pros and cons.

What is a 401(k) retirement plan?

Employers can offer a 401(k), a popular tax-advantaged savings vehicle. Once you enroll, you elect a percentage or flat dollar amount of each paycheck you want to contribute.

For 2023, you can contribute up to $22,500 or $30,000 if you’re over 50 to most workplace retirement plans. Additionally, many employers encourage saving by “matching” your contributions, allowing you to exceed those annual limits. You choose how to allocate your retirement funds using an investment menu that usually includes index, exchange-traded, and money market funds.

In most cases, 401(k) plans allow participants to take loans and hardship withdrawals up to certain limits.

What is a 401(k) loan?

A 401(k) loan isn’t technically a loan because there isn’t a lender. You tap a portion of your account tax-free if you repay it with interest and on time. While it might seem strange to repay yourself for a 401(k) loan with interest, the purpose is to compensate for the time your money isn’t invested and doesn’t grow.

The first hurdle to taking a 401(k) loan is that it must be allowed by your retirement plan. Ask your benefits administrator or review the plan’s summary plan description (SPD) document for more information. Due to the paperwork and time required to administer retirement loans, many small companies don’t offer them.

If you can take a 401(k) loan, the limit is half your vested balance, up to $50,000. For example, if you have $60,000, the maximum you can borrow is $30,000 ($60,000 x 0.5).
And if your 401(k) balance is $200,000, the most you can borrow is $50,000. You can even take multiple loans if the total doesn’t exceed $50,000.

Retirement account loans have an interest rate and term specified in the SPD. The repayment period is typically five years, but it may be longer if you use the funds to buy, build, or remodel a home. You must make payments in equal amounts that include principal and interest, which get deducted from your paychecks.

If you repay a 401(k) loan on time, you won’t owe income taxes or penalties. However, if you don’t, the outstanding balance gets considered an early withdrawal if you’re younger than 59.5. In that case, you’d be subject to income tax plus an additional 10% penalty on the entire unpaid loan amount.

Additionally, if you leave your job, get laid off, or are fired, your loan balance becomes an early withdrawal unless you repay it by your tax filing deadline. Again, if you can’t repay it by then, you’ll have to pay income tax plus the 10% penalty if you’re younger than 59.5.

What are the pros for a 401(k) loan?

If your 401(k) permits loans, here are five benefits of taking one.

1. You receive funds quickly.

Since there isn’t a 401(k) lender, you don’t have to complete an application, verify your income, or submit years of income tax returns. However, you must sign a loan document with the institution that administers your plan to agree to the interest rate, repayment terms, amount to withdraw, and account to deposit your funds, which are usually available within a week.

2. You pay a low interest rate.

The interest rate on 401(k) loans is typically lower than other debt, such as credit cards and personal loans.

3. You don’t need good credit.

Since no lender must approve you for a 401(k) loan, your credit scores aren’t a factor. You can get one no matter the state of your finances or even if you have poor credit.

4. You can spend it as you like.

You can use a 401(k) loan for any purpose. However, using it for a primary residence may qualify you for a longer repayment term. So, let your account custodian know how you plan to spend it.

5. You have a short repayment term.

Unless you use a 401(k) loan for a home, you typically must repay it in five years. A relatively short repayment term can help keep your financial life on track with less debt and more money invested for retirement.

What are the cons for a 401(k) loan?

Here are five downsides of a 401(k) loan to consider.

1. You can’t borrow more than an allowable limit.

As I mentioned, the maximum 401(k) loan is $50,000 or 50% of your vested account balance, whichever is less. And there may be a minimum loan amount, such as $1,000.

2. Your payments get deducted from your paychecks.

In general, you can’t make a lump-sum repayment for a 401(k) loan because payments get automatically deducted from your paychecks. However, some plans allow you to make monthly or quarterly loan payments or prepay your balance early.

3. Your interest is not tax-deductible.

Unlike interest paid on a mortgage or student loan, which may be partially tax-deductible, interest paid on a retirement loan is never tax-deductible. So, if you plan to use proceeds from a 401(k) loan for a home or education, you’d be better off getting a mortgage or student loan that allows a deduction, potentially reducing your tax liability.

4. You miss potential investment gains.

The purpose of a retirement account is to grow money for the future. Funds you withdraw miss potential investment growth; plus, many plans prohibit contributions for a period or until you repay a loan. Even if you repay a 401(k) loan on time, you could end up with less than if you hadn’t taken it.

For example, if you contribute $400 a month for 40 years with an average investment return of 7%, you’d have $1,056,049 in your 401(k) to kick off retirement. But let’s say you took a $50,000 loan after 20 years with a 5-year term at 4% interest and could not make contributions during the repayment period.

After 20 years, your 401(k) balance would be $209,586, and taking a $50,000 loan would reduce it to $159,586. After the five-year repayment period, your balance would be $132,736 higher due to paying yourself $917.99 monthly (principal and 4% interest), plus earning a 7% average return, or $292,322 ($159,586 account balance + $55,066 repaid + $77,670 growth).

After investing $400 a month for the remaining 15 years with a 7% average return, your balance at retirement would be $960,334. That’s $95,714 less than if you hadn’t taken the loan over the same 40-year period.

5. You could have an expensive penalty.

If you take a 401(k) loan and experience financial hardship or lose your job, repaying it may not be easy. Plus, separating from your employer for any reason means your loan balance is due by your tax filing deadline and subject to taxes plus a penalty if you’re younger than 59.5.

What is a 401(k) hardship withdrawal?

If your 401(k) doesn’t allow loans or you need more than the allowable loan amount, you may be eligible for a “hardship” withdrawal if permitted by your plan. Hardships are specific circumstances approved by the IRS, including paying for college, buying a primary home, avoiding mortgage foreclosure, making home repairs, or having unpaid medical or funeral expenses.

The downside of a 401(k) hardship withdrawal is that they’re not tax-free. You must pay income taxes plus a 10% early withdrawal penalty if you’re younger than 59.5. Plus, you can’t contribute to your retirement account for six months after taking a hardship withdrawal.

Should you raid your 401(k)?

Whether you should take a loan or hardship withdrawal from your 401(k) depends on what your plan allows, your financial circumstances, and your plan for using the funds. If you’re younger than 59.5 and have a secure job, a 401(k) loan with a relatively low interest rate may be better than a taxable hardship withdrawal.

Tapping your retirement account should be a last resort because you forfeit significant potential account growth. Instead, consider getting a home equity line of credit if you’re a homeowner. A personal loan may be a wise option if you rent or don’t have enough home equity.

If your retirement plan allows you to consult an advisor, get their customized advice, and understand your options. It’s critical to carefully consider the pros and cons before raiding your 401(k).

About the Author

Laura Adams is a money expert and spokesperson for Finder. She’s one of the nation’s leading personal finance and business authorities. As an award-winning author and host of the top-rated Money Girl podcast since 2008, millions of readers, listeners, and loyal fans benefit from her practical advice. Laura is a trusted source for media and has been featured on most major news outlets, including ABC, Bloomberg, CBS, Consumer Reports, Forbes, Fortune, FOX, Money, MSN, NBC, NPR, NY Times, USA Today, US News, Wall Street Journal, Washington Post, and more. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Her mission is to empower consumers to live healthy and rich lives by making the most of what they have, planning for the future, and making smart money decisions every day.

This article originally appeared on Finder.com and was syndicated by MediaFeed.org.