401(k) Loans: A Brief Guide

Author: Siân Killingsworth / 28 Jul 2023 / 401(k) Plan Information, Personal Finance, Small Business 401k

Whether you’re a small business owner, an employee, or just someone with a 401(k), you’re in the right place. Your 401(k) can be a valuable tool for securing your financial future, but sometimes unexpected events happen (hey, that’s life!). If you find yourself contemplating borrowing from your 401(k), it’s important to weigh the pros and cons before you make a decision. So we’re breaking down when you should – and shouldn’t – borrow from your retirement account.

What is a 401(k) Loan?

Before you borrow from your small business 401(k), it’s important to understand what you’re doing. A 401(k) loan is a borrowing option available to any individual who has a 401(k). It allows you to borrow some of the funds in your retirement account and repay it with interest over a specified period of time.

If you’re a small business owner, look for a small business 401(k) with flexibility around borrowing and changing contribution amounts.

How Does it Work?

In short: You’re borrowing money from yourself.

Essentially, the loan amount is limited to a percentage of your retirement account’s vested balance, and is paid back through regular installments, usually deducted from your paycheck with interest.

Pros of Borrowing from Your 401(k)

Quick access to funds.

• Borrowing from your 401(k) can provide a fast solution when you’re facing a financial crunch or unexpected expense. After all, the money is yours, so it’s an effective solution for time-sensitive situations

No credit check or approval process.

• Unlike traditional loans, borrowing from your 401(k) does not require a credit check or a lengthy approval process. This can be a significant advantage if you have less-than-perfect credit.

Competitive interest rates.

• The interest rates on 401(k) loans are often lower compared to other borrowing options, such as credit cards or personal loans.

Repayment benefits you.

• When you repay the loan, the interest payments go back into your 401(k) account, helping you to recoup some of the money you borrowed.

Cons of Borrowing from Your 401(k):

Impact on retirement savings.

• By borrowing from your 401(k), you’re potentially tapping into the savings you’ve diligently set aside for retirement.
• This could hinder your long-term financial security if the borrowed amount is not replenished promptly.

Limited growth potential.

• The money you borrow from your 401(k) is temporarily removed from investments, which means it won’t benefit from potential market gains during that period.
• You’ll also miss out on earning compound interest during the payback period.

Repayment challenges.

• If you leave your job or your business fails, the loan may become due in full, which can create a financial burden.

Tax implications.

• If you’re unable to repay the loan within the specified timeframe, the borrowed amount could be subject to income tax and potentially early withdrawal penalties.
• If you take a full withdrawal instead of a loan, you’re subject to a 10% early withdrawal penalty – and the money is taxed as income, potentially costing thousands.

In a financial emergency, borrowing funds from your small business 401(k) should be used as a last resort because of the drawbacks, but we understand that sometimes financial challenges don’t present other options.

While borrowing from your 401(k) can be an option in certain situations, it’s important to carefully consider the potential pros and cons. By assessing your financial needs, exploring alternatives, and having a clear repayment strategy, you can make an informed decision about borrowing from your small business 401(k). Remember, it’s crucial to strike a balance between present financial needs and securing a comfortable retirement. Plan wisely and consult with a financial advisor if needed, so you can make the best choices for your financial future.

 

Please see Important Information for details.