Pros and Cons of Taking Out a 401(k) Loan for Emergency Expenses

Author: Andrew Meadows / 28 Jun 2023 / 401(k) Plan Information, Personal Finance

If you’re a small business owner, employee, or just someone facing a financial emergency and wondering if you should take a 401(k) loan from your small business retirement account, this one’s for you. While this may provide a temporary (or even longer-term) solution to your financial needs, it’s important to weigh the pros and cons before you pull money from your retirement account.

Understanding 401(k) Loans

What is a 401(k) loan?

A 401(k) loan is a borrowing option available to individuals who have a 401(k). It allows you to borrow a portion of the funds you have contributed to your 401(k) and repay it with interest over a specified period of time.

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

How does it work?

When you take out a 401(k) loan, you essentially borrow money from yourself. The loan amount is typically limited to a percentage of your vested balance in the 401(k) account. You pay it back through regular installments that are usually deducted from your paycheck.

Pros of Taking Out a 401(k) Loan for Emergency Expenses

Quick access to funds

401(k) loans can be processed relatively quickly, allowing you to address your emergency expenses promptly.

No credit check

This can benefit individuals with a less-than-perfect credit history, as your credit score does not determine your eligibility for the loan.

Lower interest rates

Compared to other forms of borrowing, such as personal loans or credit cards, 401(k) loans often have lower interest rates. The interest payments also go back into your account, making it a more cost-effective option for interest expenses.

Repayment flexibility

401(k) loans typically offer flexible repayment options. You can choose the loan duration, usually one to five years, and make regular payments through automatic deductions from your paycheck.

Cons of Taking Out a 401(k) Loan for Emergency Expenses

Potential reduction in retirement savings

When you borrow from your 401(k), the borrowed amount is no longer invested in the market, which means you miss out on potential market gains and compound interest.

Limited borrowing capacity

Some 401(k) loans have limitations on how much you can borrow. Although some providers allow loans up to the total amount of money in your account, for other providers, the maximum loan amount is typically capped at either $50,000 or 50% of your vested account balance, whichever is lower. Make sure you check with your provider what is permitted.

Repayment challenges

Loan repayments are deducted from your paycheck, reducing your take-home pay during the repayment period, so if you’re borrowing from your 401(k), make sure you’ve budgeted for a lower take home income.

Penalties and taxes for defaulting

Defaulting on a 401(k) loan can result in severe penalties and taxes. For example, the outstanding loan balance could be treated as a distribution, subjecting you to income tax and potentially early withdrawal penalties if you are under the age of 59½.

Opportunity cost of missed market gains

By borrowing from your 401(k), you miss out on potential market gains that your retirement savings could have generated. This opportunity cost should be carefully considered before opting for a 401(k) loan.

Alternatives to 401(k) Loans for Emergency Expenses

Emergency savings fund

Experts recommend having between three and six months of income saved up (just in case).

Personal loans

If you have a good credit history, obtaining a personal loan from a financial institution may offer competitive interest rates and more favorable terms than a 401(k) loan.

Credit cards

Credit cards can be a convenient short-term solution for emergency expenses–if you use them responsibly.

Home equity loans

If you own a home, leveraging the equity you have built can be an option for accessing funds in times of emergency (and often has a lower interest rate).

Factors to Consider Before Taking Out a 401(k) Loan

Before deciding to take out a 401(k) loan for emergency expenses, it’s essential to consider several factors, including financial stability, the impact of a loan on your retirement goals, and the limitations of borrowing. Weigh the pros and cons, as well as the alternatives–and if you still have questions, our small business 401(k) experts are always here to help (and here are some reasons you should chat with them).

 

Ubiquity is not a registered investment advisor, and the information provided herein should not be considered legal or tax advice. We recommend consulting with your financial planner, attorney, and/or tax advisor for personalized advice.