401(k) loans allow you to borrow money from a 401(k) account or certain other qualifying retirement plans, such as a 403(b). 401(k) loans have certain benefits over other types of financing, including lower interest rates and the ability to access funds without triggering a credit check.
Secured debts are those for which the borrower puts up some asset to serve as collateral for the loan. The secured loans lower the amount of risk for lenders. Unsecured debt has no collateral backing. Lenders issue funds in an unsecured loan based solely on the borrower's creditworthiness and promise to repay.
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.
All the positives still apply plus the repayment time frame is usually longer. On the downside, though, borrowers would not receive tax deductions for the interest paid on the loans the way they would with other forms of credit and the impact of an even longer-term loan on retirement goals would be compounded.
401(k) Loan Pros
You may be able to qualify for a lower interest rate than you could with a credit card or personal loan. You're paying interest back to yourself, rather than to a bank or lender. There's no credit check required and a 401(k) loan won't show up on your credit report.
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.
A low credit score won't result in a rejected application. 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.
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.
While you'll pay yourself back, you're still removing money from your retirement account that is growing tax-free. 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.
Since secured loans will often have lower interest rates and higher borrowing limits, they may be the best option if you're confident about being able to make timely payments. That said, an unsecured loan may be the best choice if you don't want to place your assets at risk.
1. Payment History: 35% Your payment history carries the most weight in factors that affect your credit score, because it reveals whether you have a history of repaying funds that are loaned to you.
A credit card cannot be used to secure a debt because it represents unsecured debt, unlike physical items such as a house or a car, which can serve as collateral.
Loan amounts are from $1,000 to $100,000, and rates are 6% to 36%. They're usually repaid in monthly installments over a term from two to seven years. These loans are unsecured, so there's no collateral required.
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.
Borrowing from your 401(k) may be the best option, although it does carry some risk. Alternatively, consider the Rule of 55 as another way to withdraw money from your 401(k) without the tax penalty.
Sometimes, it may be your best option for handling a current cash need or an emergency. Interest rates are generally low (1 or 2 percent above the prime rate) and paperwork is minimal. But a 401(k) loan is just that—a loan. And it needs to be paid back with interest.
As a general rule, if you withdraw funds before age 59 ½, you'll trigger an IRS tax penalty of 10%. The good news is that there's a way to take your distributions a few years early without incurring this penalty. This is known as the rule of 55.
You end up paying taxes on your loan repayments—twice.
Your 401(k) loan repayments, on the other hand, get no special tax treatment. In fact, you'll be taxed not once, but twice on those payments. First, the loan repayments are made with after-tax dollars (that means the money going in has already been taxed).
An advantage of a 401(k) loan over a withdrawal is you don't pay ordinary income taxes or face potential additional taxes on the borrowed amount. You must repay the loan along with interest, per the loan terms; but on the bright side, repayments replenish your plan account — you're essentially repaying yourself.
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 may not get approved: Those nearing retirement may be considered “higher risk” and thus denied a 401(k) loan because payments will no longer automatically come out of their paychecks.
Dipping into a 401(k) or 403(b) before age 59 ½ usually results in a 10% penalty. For example, taking out $20,000 will cost you $2000.
Roll over your 401(k) to a Roth IRA
You can roll Roth 401(k) contributions and earnings directly into a Roth IRA tax-free. Any additional contributions and earnings can grow tax-free. You are not required to take RMDs. You may have more investment choices than what was available in your former employer's 401(k).
The short answer is that yes, you can withdraw money from your 401(k) before age 59 ½. However, early withdrawals often come with hefty penalties and tax consequences.