Here's what you need to know about 401(k) withdrawals and loans—plus alternatives.
Note: The CARES Act may allow you to take a withdrawal due to illness or loss of income related to COVID-19. Check with your plan provider to view your withdrawal options.
- Explore all your options for getting cash before tapping your 401(k) savings.
- Every employer's plan has different rules for 401(k) withdrawals and loans, so find out what your plan allows.
- Your workplace retirement plan may offer a CARES Act withdrawal option. If you qualify, it might be an option to consider.
- If you don't qualify for a CARES Act withdrawal and you are able to make repayments, a 401(k) loan may be a better option than a traditional hardship withdrawal, if it's available. In most cases, loans are an option only for active employees.
- If you opt for a 401(k) loan or withdrawal, take steps to keep your retirement savings on track so you don't set yourself back.
No one opens and contributes to a workplace savings account like a 401(k) or a 403(b) expecting to need their hard-earned savings before retirement. But if you find you need money, and no other sources are available, your 401(k) could be an option. The key is to keep your eye on the long-term even as you deal with short-term needs, so you can retire when and how you want.
Loans and withdrawals from workplace savings plans (such as 401(k)s or 403(b)s) are different ways to take money out of your plan.
- 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.
Let's look at the pros and cons of different types of 401(k) loans and withdrawals, including those under the new CARES Act—as well as alternative paths. Be sure to consult a financial representative for assistance navigating your options.
401(k) withdrawals vs. loans: Look at the pros and cons
You may be eligible for a CARES Act distribution if you, your spouse, or dependent have been diagnosed with COVID-19, or you have experienced adverse financial consequences due to COVID-19.
If that's the case for you, the 10% early withdrawal penalty for people under 59½ is waived for up to $100,000 taken out of a 401(k), 403(b), or 457 retirement plan, as well as an IRA, through the end of 2020.
You also have the option to pay the federal income tax on the withdrawal—or repay the full withdrawal amount—over a three year period. All employer plans are different, so be sure to find out what yours allows and determine whether your employer will accept repayments.
If you don't qualify for a CARES Act withdrawal, you might qualify for a traditional withdrawal, such as a hardship withdrawal. The IRS defines a hardship as having an immediate and heavy financial need like a foreclosure, tuition payments, or medical expenses. Also, some plans allow a non-hardship withdrawal, but all plans are different, so check with your employer for details.
Pros: You're not required to pay back withdrawals and 401(k) assets. If you qualify for a CARES Act withdrawal, you can avoid penalties, and you might be able to spread out the federal income taxes over a three year period or pay the withdrawal back to avoid taxes altogether.
Cons: A non-CARES Act withdrawal can have a big impact on your retirement savings because it permanently removes money from your account. If you're under the age of 59½ and take a traditional withdrawal, you won't get the full amount because of the 10% penalty and the taxes that you will pay up front as part of your withdrawal.
With a 401(k) loan, you borrow money from your retirement savings account. Depending on what your employer's plan allows, you could take out as much as 50% of your savings, up to a maximum of $50,000, within a 12-month period. Note that the CARES Act permits plans to offer increased loan limits above the $50,000 standard limit. However, not all employers have adopted the new CARES Act provisions, so check with your employer to see what options you might have.
Remember, you'll have to pay that borrowed money back, plus interest, within five years of taking your loan, in most cases. Your plan's rules will also set a maximum number of loans you may have outstanding from your plan. You may also need consent from your spouse/domestic partner to take a loan.
Pros: Unlike 401(k) withdrawals, you don't have to pay taxes and penalties when you take a 401(k) loan. Plus, the interest you pay on the loan goes back into your retirement plan account. Another benefit: If you miss a payment or default on your loan from a 401(k), it won't impact your credit score because defaulted loans are not reported to credit bureaus.
Cons: If you leave your current job, you might have to repay your loan in full in a very short time frame. The CARES Act provides for a delay of repayments that may be available in your plan. But if you can't repay the loan for any reason, it's considered defaulted, and you'll owe both taxes and a 10% penalty if you're under 59½. You'll also lose out on investing the money you borrow in a tax-advantaged account, so you'd miss out on potential growth that could amount to more than the interest you'd repay yourself.
Immediate impact of taking $15,000 from a $38,000 account balance
Assumptions: See footnote 1.
Is it a good idea to borrow from your 401(k)?
Using a 401(k) loan for elective expenses like entertainment or gifts isn't a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what's been discussed so far, borrowing from your 401(k) might be beneficial long-term—and could even help your overall finances. For example, using a 401(k) loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What's more, 401(k) loans don't require a credit check, and they don't show up as debt on your credit report.
Another potentially positive way to use a 401(k) loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401(k) loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you're paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
Assumptions: See footnote 2.
What are alternatives?
Because withdrawing or borrowing from your 401(k) has drawbacks, it's a good idea to look at other options and only use your retirement savings as a last resort. A financial representative can provide guidance based on your personal financial situation.
A few possible alternatives to consider include:
- Using HSA savings, if it's a qualified medical expense
- Tapping into emergency savings
- Transferring higher interest credit card balances to a new lower (or zero) interest credit card
- Using other non-retirement savings, such as checking, savings, and brokerage accounts
- Using a home equity line of credit or a personal loan3
- Withdrawing from a Roth IRA—these withdrawals are usually tax- and penalty-free