How does borrowing against your 401k work

In fact, in some cases, it can even have a positive impact. Let's dig a little deeper to explain why. Technically, k loans are not true loans, because they do not involve either a lender or an evaluation of your credit history. You then must repay the money you have accessed under rules designed to restore your k plan to approximately its original state as if the transaction had not occurred. Another confusing concept in these transactions is the term interest.

Any interest charged on the outstanding loan balance is repaid by the participant into the participant's own k account, so technically, this also is a transfer from one of your pockets to another, not a borrowing expense or loss. As such, the cost of a k loan on your retirement savings progress can be minimal, neutral, or even positive. But in most cases, it will be less than the cost of paying real interest on a bank or consumer loan.

The top four reasons to look to your k for serious short-term cash needs are:. In most k plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit score. Many k s allow loan requests to be made with a few clicks on a website, and you can have funds in your hand in a few days, with total privacy. One innovation now being adopted by some plans is a debit card , through which multiple loans can be made instantly in small amounts.

Although regulations specify a five-year amortizing repayment schedule , for most k loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions —using after-tax dollars, though, not the pretax ones funding your plan.

Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement. There is no cost other than perhaps a modest loan origination or administration fee to tap your own k money for short-term liquidity needs. Here's how it usually works:. You specify the investment account s from which you want to borrow money, and those investments are liquidated for the duration of the loan.

Therefore, you lose any positive earnings that would have been produced by those investments for a short period. And if the market is down, you are selling these investments more cheaply than at other times. The upside is that you also avoid any further investment losses on this money. The cost advantage of a k loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed.

Here is a simple formula:. Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. Keep in mind that this calculation ignores any tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars. As you make loan repayments to your k account, they usually are allocated back into your portfolio's investments. You will repay the account a bit more than you borrowed from it, and the difference is called "interest.

If the interest paid exceeds any lost investment earnings, taking a k loan can actually increase your retirement savings progress. Keep in mind, however, that this will proportionally reduce your personal non-retirement savings.

The above discussion leads us to address another erroneous argument regarding k loans: By withdrawing funds, you'll drastically impede the performance of your portfolio and the building up of your retirement nest egg. That's not necessarily true. First of all, as noted above, you do repay the funds, and you start doing so fairly soon. Given the long-term horizon of most k s, it's a pretty small and financially irrelevant interval.

The percentage of k participants with outstanding plan loans in latest information , according to a study by the Employee Benefit Research Institute. The other problem with the bad-impact-on-investments reasoning: It tends to assume the same rate of return over the years and—as recent events have made stunningly clear—the stock market doesn't work like that.

A growth-oriented portfolio that's weighted toward equities will have ups and downs, especially in the short term. If your k is invested in stocks, the real impact of short-term loans on your retirement progress will depend on the current market environment. The impact should be modestly negative in strong up markets, and it can be neutral, or even positive, in sideways or down markets.

The grim but good news: the best time to take a loan is when you feel the stock market is vulnerable or weakening, such as during recessions. Coincidentally, many people find that they need funds or to stay liquid during such periods. There are two other common arguments against k loans: The loans are not tax-efficient and they create enormous headaches when participants can't pay them off before leaving work or retiring.

Let's confront these myths with facts:. The claim is that k loans are tax-inefficient because they must be repaid with after-tax dollars, subjecting loan repayment to double taxation. Only the interest portion of the repayment is subject to such treatment. The media usually fail to note that the cost of double taxation on loan interest is often fairly small, compared with the cost of alternative ways to tap short-term liquidity.

She anticipates that she can repay this money from her salary in about a year. Here are three ways she can tap the cash:. Double taxation of k loan interest becomes a meaningful cost only when large amounts are borrowed and then repaid over multi-year periods.

Suppose you take a plan loan and then lose your job. You will have to repay the loan in full. While this scenario is an accurate description of tax law, it doesn't always reflect reality.

At retirement or separation from employment, many people often choose to take part of their k money as a taxable distribution, especially if they are cash-strapped.

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That's why we provide features like your Approval Odds and savings estimates. Of course, the offers on our platform don't represent all financial products out there, but our goal is to show you as many great options as we can. Provided your k plan permits loans, borrowing from your k may help you pay bills, fund a big purchase or make a down payment on a home. If your employer provides a k retirement savings plan, it may choose to allow participants to borrow against their accounts — although not every plan will let you do so.

As long as you have a vested account balance in your k , and if your plan permits loans, you can likely be allowed to borrow against it. Our experts have been helping you master your money for over four decades. Bankrate follows a strict editorial policy , so you can trust that our content is honest and accurate. The content created by our editorial staff is objective, factual, and not influenced by our advertisers.

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The information on this site does not modify any insurance policy terms in any way. A k is an employer-sponsored retirement savings plan that lets you set aside pre-tax dollars or after-tax dollars if you have a Roth k from your paycheck to help fund your years after you stop working. According to IRS rules, you have five years to pay back the loan, unless the funds are used to buy your main home, in which case you have more time to repay.

A k loan has some key disadvantages, however. And the less money in your plan, the less money that grows over time. Even when you pay the money back, it has less time to fully grow. You may not get one. Having the option to get a k loan depends on your employer and the plan they have set up. A study from retirement data firm BrightScope and the Investment Company Institute says that 78 percent of plans gave participants the option to borrow based on data. So you may need to seek funds elsewhere.

You have limits. You might not be able to access as much cash as you need. You could pay taxes and penalties on it. Under the new tax law, k borrowers have until the due date of their federal income tax return to repay in such circumstances.

The old rule called for repayment within 60 days. A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis. One alternative to a k loan is a hardship distribution as part of an early withdrawal , but that comes with all kinds of taxes and penalties.

A hardship distribution through an early withdrawal covers a few different circumstances, including:. Here are a few ways to sidestep those hefty levies and keep your retirement on track. Here are a few other places to find money.