Since the 401(k) loan isn't technically a debt—you're withdrawing your own money, after all—it has no effect on your debt-to-income ratio or on your credit score, two big factors that influence lenders.
Moreover, a 401(k) loan won't affect your credit at all — even if you default on it. Low interest rates. You'll pay a modest interest rate and this money goes straight into your retirement account.
A 401(k) loan will not affect your mortgage or mortgage application. A 401(k) loan has no effect on either your debt-to-income ratio or your credit score, two big factors that influence mortgage lenders.
Any money borrowed from a 401(k) account is tax-exempt, as long as you pay back the loan on time. And you're paying the interest to yourself, not to a bank. You do not have to claim a 401(k) loan on your tax return.
A loan lets you borrow money from your retirement savings and pay it back to yourself over time, with interest—the loan payments and interest go back into your account. A withdrawal permanently removes money from your retirement savings for your immediate use, but you'll have to pay extra taxes and possible penalties.
Overall, you should only take on a loan from your 401(k) if you have exhausted all other funding options because taking money out of your 401(k) means you're hindering it from the most growth over time. You'll be missing out on the power of compound interest when you take money out of your retirement account.
Loans are not taxable distributions unless they fail to satisfy the plan loan rules of the regulations with respect to amount, duration and repayment terms, as described above. In addition, a loan that is not paid back according to the repayment terms is treated as a distribution from the plan and is taxable as such.
You're missing out on investment growth
When you reduce the balance of your 401(k) account, you have less money growing along with potential gains in the market. In addition, some 401(k) plans have terms that prevent you from being able to make further contributions until the loan is repaid.
If you don't repay the loan, including interest, according to the loan's terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job.
When will the loan be due? The “termination date” will either be your last day of employment with the company or the date your employer set as the last day the plan is active. You must pay off the loan in full no later than 90 days from the termination date.
You can do a 401(k) withdrawal while you're still employed at the company that sponsors your 401(k), but you can only cash out your 401(k) from previous employers.
Key takeaways. Using a 40(k) loan to purchase a car could be a smart move if it's the least expensive option. Before using this option, consider the potential drawbacks, including fees and missing out on potential investment gains.
By allowing loans, employees know they'll be able to use the funds if they need to. When they do take a retirement loan, it's a non-taxable event. That means an employee doesn't claim a 401(k) loan when they file their taxes.
Some plans might process loans quickly, within a few days, while others might take a couple of weeks.
Lower interest rate: The interest rate on a 401(k) loan is lower compared to other retail lending options. Typically, it's the prime rate plus 1% to 2%. As of November 2023, the prime rate is 8.50%, which makes a 401(k) loan about 9.50% to 10.50% APR, depending on your plan's administrator.
Rules of taking out a 401(k) loan are as follows:
There is a 12 month "look back" period, which means you can borrow up to 50% of your total vested balance of all accounts you owned for the last 12 months, reduced by the highest outstanding balance over this look back period.
Deferring Social Security payments, rolling over old 401(k)s, setting up IRAs to avoid the mandatory 20% federal income tax, and keeping your capital gains taxes low are among the best strategies for reducing taxes on your 401(k) withdrawal.
The easiest way to borrow from your 401(k) without owing any taxes is to roll over the funds into a new retirement account. You may do this when, for instance, you leave a job and are moving funds from your former employer's 401(k) plan into one sponsored by your new employer.
Deciding whether to use a 401(k) to pay down debt depends on your financial position. Early withdrawal from your 401(k) can cost you in taxes and fees and isn't often recommended unless absolutely necessary.
Take Out a 401(k) Loan
Your 401(k) plan may permit you to take out a 401(k) loan and forgo the income taxes and penalty associated with an early withdrawal. While you'll be required to repay the loan with interest within five years, you'll be repaying yourself.
In some cases, you might be able to withdraw funds from a 401(k) to pay off debt without incurring extra fees. This is true if you qualify as having an “immediate and heavy financial need,” and meet IRS criteria. In those circumstances, you could take a hardship withdrawal.
In retirement, you can withdraw only as much as you need to live, and allow the rest to remain invested. You can also choose to use your 401(k) funds to purchase an annuity that will pay out guaranteed lifetime income.
Though there are exceptions, many plans require you to pay off your 401(k) loan in full when you leave your job. Check your plan's summary plan description for details on whether and when you are required to pay.
How Do I Repay a 401(k) Loan? Like 401(k) contributions, loan repayments are typically made through payroll deductions. In general, a 401(k) loan must be paid back within five years, unless the funds are used to purchase a home.