While it's beneficial to pay off your loan early, doing so might strain your cash flow. Make sure that paying off your 401(k) loan won't leave you short of cash for other important expenses or emergency savings.
If you have a high-interest debt, such as from a credit card with a big balance, you may get a much lower interest rate on a 401(k) loan. If you have upcoming debt payments and no other alternatives for paying them, borrowing from your 401(k) can reduce fees and penalties.
To borrow money, you remove it from investment in the market, forfeiting potential gains. Calculate your potential losses carefully. Borrowed funds are taxed twice.
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.
Generally, the employee must repay a plan loan within five years and must make payments at least quarterly. The law provides an exception to the 5-year requirement if the employee uses the loan to purchase a primary residence.
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.
401(k) loans accrue interest, which is typically a few points above the prime interest rate. 1 But that interest is paid back into your account, so you don't lose it to a lender.
For employees that have pre-tax dollars within their 401(k) plans, when you take a loan, it is not a taxable event, but the 401(k) loan payments are made with AFTER TAX dollars, so as you make those loan payments you are essentially paying taxes on the full amount of the loan over time, then once the money is back in ...
Money withdrawn from your 401(k) account will not be earning interest, so your retirement savings might not grow at the same rate. Using a personal loan to consolidate debt may save you money in interest on higher-rate debts which could help you manage your budget effectively or add to your savings.
Pros. 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.
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.
401(k) loans usually have single-digit interest rates, making them cheaper than credit cards. Interest typically equals the prime rate plus one percentage point. The interest you pay goes back into your own account.
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.
However, there may come a time when you need money and have no choice but to pull funds from your 401(k). Two viable options include 401(k) loans and hardship withdrawals. A 401(k) loan is generally more attainable than a hardship withdrawal, but the latter can come in handy during times of financial strife.
Typically, retirement plans charge the current prime rate plus 1% or 2% in interest on 401(k) loans. That interest, along with your repayments, is deposited into your account. Keep in mind that although it's like paying yourself back, you're doing it with after-tax funds.
Let's say your plan loan is secured by your 401(k) or 403(b) account balance. If any of that balance is from your elective deferrals, you can't deduct any of the interest. It doesn't matter how you use the loan proceeds.
Myth 3: You'll pay taxes twice.
However, that statement greatly exaggerates the tax costs of taking a 401(k) loan; the only money "taxed twice" in the transaction is the interest paid. Meanwhile, the 401(k) borrower is able to take the loan, consisting of money that has never been taxed, without tax consequences.
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.
As much as you may need the money now, by taking a distribution or borrowing from your retirement funds, you're interrupting the potential for the funds in your 401(k) plan account to grow through tax-deferred compounding — and that could make it more difficult for you to reach your retirement goals, says Feist.
One of those tools is known as the Rule 72. For example, let's say you have saved $50,000 and your 401(k) holdings historically has a rate of return of 8%. 72 divided by 8 equals 9 years until your investment is estimated to double to $100,000.
Contributions and earnings in a Roth 401(k) can be withdrawn without paying taxes and penalties if you are at least 59½ and had your account for at least five years. Withdrawals can be made without penalty if you become disabled or by a beneficiary after your death.
Remember that the rules about the 15th business day isn't a safe harbor for depositing deferrals; rather, that these rules set the maximum deadline. DOL provides a 7-business-day safe harbor rule for employee contributions to plans with fewer than 100 participants.
Some of the ways you can use to pay off the 401(k) loan early include making extra payments, rounding off loan payments, borrowing to pay the loan, taking up a second job, and selling idle personal assets to raise money to pay off the debt.