Blogging for Change

Borrowing from Your 401k

by Jesse Campbell on
1/9/2025
in Using Credit
Mature couple having conversation in the kitchen.

When you’re faced with financial challenges, borrowing from your 401(k) or other retirement accounts may seem like an attractive solution. While it offers quick access to cash, it’s not without risks and long-term consequences. Understanding how cashing out retirement to pay off debt works – and its limitations and potential costs – can help you make a more informed decision.

How does borrowing from a 401(k) work?

If you’re looking to take money out of your 401k, a 401(k) loan allows you to borrow from the savings in your retirement account. The loan must be repaid, typically with interest, but unlike traditional loans, the interest goes back into your account. Before borrowing from your retirement accounts, you need to be aware of common 401k withdrawal rules:

  • Borrowing limits: You can borrow up to 50% of your vested balance, or $50,000—whichever is less.
  • Repayment terms: The standard repayment period is five years, although loans used to purchase a primary residence may have longer terms.
  • Payments: Repayments are usually deducted directly from your paycheck.
  • Employment impact: If you leave your job before repaying the loan, you must pay the remaining balance by the tax filing deadline for that year. Failure to do so can result in the outstanding amount being treated as a taxable distribution, potentially incurring a 10% early withdrawal penalty if you’re under 59½.

Not all 401(k) plans allow loans, so review the terms of your specific plan or consult your plan administrator to understand your options.

What are the pros and cons of borrowing from a 401(k)?

Advantages

  • Quick access to funds: Borrowing from your 401(k) can be faster than obtaining a personal loan or home equity loan.
  • No credit impact: This type of loan doesn’t appear on your credit report, and no credit check is required.
  • Low interest rates: The interest rate is usually the prime rate plus 1-2%, and the interest payments go back into your retirement account.
  • No tax penalties (if repaid on time): As long as the loan is repaid according to the terms, there are no tax implications.

Disadvantages

  • Lost investment growth: The money you borrow isn’t invested, meaning you miss out on potential compound growth during the loan period.
  • Risk of job loss: If you leave your job, any unpaid balance becomes due, often immediately. Failure to repay it in time may result in penalties and taxes.
  • Double taxation: Loan repayments are made with after-tax dollars. When you withdraw the money in retirement, it will be taxed again.
  • Reduced contributions: Borrowers often reduce or stop 401(k) contributions while repaying the loan, slowing the growth of their retirement savings.
  • Risk of default: Failing to repay the loan converts it into a taxable distribution, potentially with penalties if you’re under 59½.

What is the cost of borrowing from a 401(k)?

While the interest rates on 401(k) loans are low compared to other borrowing options, the true cost of cashing out retirement lies in the opportunity cost of lost investment growth. Over time, missing out on compounding returns can have a significant impact on your retirement savings. Additionally, the repayment process uses after-tax income, which may reduce the overall value of your retirement funds.

What are safe alternatives to borrowing from a 401(k)?

Before borrowing from your retirement account, consider these alternatives:

  • Emergency savings: Tap into a designated emergency fund if available.
  • Debt management plan (DMP): A DMP can help consolidate and simplify debt payments without the need to borrow from your retirement savings.
  • Personal loans or home equity loans: While these may have higher interest rates, they don’t compromise your retirement savings.
  • Budget adjustments: Evaluate discretionary spending and reallocate funds to cover immediate needs.

When does it make sense to borrow money from your 401(k)?

In certain situations, borrowing from your 401(k) can be a viable option. If you have a solid plan to repay the loan within the required timeframe and without disrupting your retirement contributions, borrowing from your 401(k) may work for you.

Additionally, some plans allow extended repayment terms for loans used to buy a primary residence.

However, even in these cases, borrowing from your 401(k) should be a last resort after exploring all other options.

Borrowing from your retirement accounts has serious long-term implications, and it’s not a decision to take lightly. If you’re considering this step, talk to a financial counselor first. At MMI, we can help you evaluate your financial situation, explore alternatives, and create a plan to address your needs without jeopardizing your future. Best of all, financial counseling is free and available 24/7, online and over the phone.

Tagged in Retirement, Loans

Jesse Campbell photo.

Jesse Campbell is the Content Manager at MMI, with over ten years of experience creating valuable educational materials that help families through everyday and extraordinary financial challenges.

Recommended Articles

Retired man and his dog
Take Control of Your Credit
Your credit is much too important to leave to chance. If you have questions about your credit report and credit score, consider scheduling a one-on-one credit report review.
Learn More
Learn more
  • Better Business Bureau A+ rating Better Business Bureau
    MMI is proud to have achieved an A+ rating from the Better Business Bureau (BBB), a nonprofit organization focused on promoting and improving marketplace trust. The BBB investigates charges of fraud against both consumers and businesses, sets standards for truthfulness in advertising, and evaluates the trustworthiness of businesses and charities, providing a score from A+ (highest) to F (lowest).
  • Financial Counseling Association of America Financial Counseling Association of America
    MMI is a proud member of the Financial Counseling Association of America (FCAA), a national association representing financial counseling companies that provide consumer credit counseling, housing counseling, student loan counseling, bankruptcy counseling, debt management, and various financial education services.
  • Trustpilot Trustpilot
    MMI is rated as “Excellent” (4.9/5) by reviewers on Trustpilot, a global, online consumer review platform dedicated to openness and transparency. Since 2007, Trustpilot has received over 116 million customer reviews for nearly 500,000 different websites and businesses. See what others are saying about the work we do.
  • Department of Housing and Urban Development - Equal Housing Opportunity Department of Housing and Urban Development
    MMI is certified by the U.S. Department of Housing and Urban Development (HUD) to provide consumer housing counseling. The mission of HUD is to create strong, sustainable, inclusive communities and quality affordable homes for all. HUD provides support services directly and through approved, local agencies like MMI.
  • Council on Accreditation Council On Accreditation
    MMI is proudly accredited by the Council on Accreditation (COA), an international, independent, nonprofit, human service accrediting organization. COA’s thorough, peer-reviewed accreditation process is designed to ensure that organizations like MMI are providing the highest standard of service and support for clients and employees alike.
  • National Foundation for Credit Counseling National Foundation for Credit Counseling
    MMI is a longstanding member of the National Foundation for Credit Counseling® (NFCC®), the nation’s largest nonprofit financial counseling organization. Founded in 1951, the NFCC’s mission is to promote financially responsible behavior and help member organizations like MMI deliver the highest-quality financial education and counseling services.