Can you borrow money from your 401(k)?

If you've got a decent amount invested in your 401(k) and need a short-term loan, you may be considering borrowing from the popular retirement vehicle. 

There are many things to consider before you take out a loan from your 401(k), including potential penalties, taxes and the possibility of a smaller retirement nest egg. 

Before you many any major financial decisions, it may be wise to consult with a financial adviser who can explain the impact. 

Can you borrow from your 401(k)?

If your plan allows it, you can borrow up to $50,000 or half your vested balance, whichever is smaller, according to the Internal Revenue Service. Many 401(k) plans, which are administered through employers, give borrowers up to five years to pay the loan back - with interest. 

There is an exception: If your 401(k) has a vested balance of less than $10,000, you can borrow up to $10,000. However, the IRS doesn't require plans to include this exception, so check with your plan administrator.

You'll also want to double-check that borrowing from the 401(k) plan is an option (your plan may require approval from your spouse). Again, speak with a financial adviser to see if this way of accessing funds makes the most sense for you. 

Can you borrow from your 401(k) without penalty?

Depending on what your plan allows, you could take out as much as 50% up to a maximum of $50,000, within a 12-month period. If you repay under the loan's terms, you won't be penalized.

But be careful: If you lose your job and don't repay by that year's tax deadline, the IRS considers your loan a withdrawal. That means if you're younger than 59 ½, you may have to pay the 10% early withdrawal tax penalty.

You can also do some rough math on early withdrawal costs by using a 401(k) calculator.

How to borrow against your 401(k)

You must apply for the 401(k) loan and meet certain requirements, which can depend on the plan's administrator. Typically, a 401(k) borrower has to pay back the loan within five years. Most plans require payments at least quarterly, or every three months.

There are some exceptions – again, it depends on the administrator. For instance, if you use the 401(k) loan to buy a home that will be your main residence, the five-year payback requirement can be waived.

Pros and cons of borrowing from your 401(k)

Experts note investing steadily over the long term is the best way to ensure you have funds for retirement. So it's a good idea to carefully consider the pros and cons of borrowing from your 401(k).

Pros 

• A 401(k) loan doesn't trigger a "hard" credit inquiry from the credit reporting firms and doesn't appear on your credit report.
• Interest rates are set by the plan administrator and can be less than other kinds of loans.
• Interest on the loan goes back into the 401(k). You pay your own account for the loan.
• If you miss a payment on a 401(k) loan it won't impact your credit score
• If you use the loan to pay off high-interest credit cards and pay the 401(k) loan back on time, you could reduce the amount you pay in interest overall.

Cons

• If you lose your job, you may have to repay the loan in full.
• Similarly, if you lose your job and don't repay the loan by that year's tax deadline, the IRS may consider your loan a withdrawal. If you're younger than 59 ½, you'll likely owe a 10% early withdrawal tax penalty.
• You can end up with a smaller retirement nest egg. That's because investment gains will build off a smaller base while your loan is outstanding.
• If you stop contributing to the plan during the loan, you may miss out on matching funds offered by some employers.

Other options

• A "hardship" withdrawal from your 401(k): There are a few exemptions from penalties usually associated with early withdrawal from a 401(k) loan, though the requirements are strict. For example, under the 2020 CARES act, you can withdraw up to $100,000 from a retirement plan to pay for issues related to COVID-19.  Check terms carefully, as there are often penalties for withdrawing 401(k) funds early and withdrawals may count as income, meaning you'll pay taxes.
• Personal loan: If your credit score is good and you have room in your budget for payment, a personal loan may make more sense than tapping into your retirement funds. Learn more about personal loans here.

• Home equity loan: If your home is valued at more than the current mortgage on the property - known as equity - you might consider this type of borrowing. Typically, home equity loans, or HELOs, have lower interest rates than other loans because your house acts as collateral.