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Education Center » Borrowing from the Bank of You: Should you take a loan from your retirement account?

Borrowing from the Bank of You: Should you take a loan from your retirement account?


When faced with an unexpected expense, you may be tempted to borrow from your retirement account. Here are things to consider before tapping into those funds.

Since the day you enrolled in your employer’s retirement plan, your retirement account has been earmarked for one of the biggest expenses you’ll ever face: retirement. Once you retire, it could be your primary source of income, used to pay for everything — from groceries and prescriptions to utility bills and travel expenses.

Whether it’s a home renovation project, an extensive car repair or unanticipated medical bill, chances are you’ll encounter an unexpected expense before you retire. If you do, you might consider taking a loan from your retirement account to cover it.

You may think that a 401(k) plan account loan seems like a good option. After all, it’s money you’ve already earned and put aside, and of course, you’re totally planning to pay it back. But, in many cases, raiding your retirement account before you retire might not be the best option. So, before you make your decision, take time to review the potential drawbacks and the potential benefits.

Think about tomorrow’s consequences before you borrow for today

As appealing as it may seem, taking a loan from your retirement account has potential disadvantages.

You’ll reduce your take-home pay. Understand that loan payments will come out of your paycheck (as they ultimately would for any other loan). This means that until your loan is paid in full, you’ll have to learn to get by on less. Before pulling the trigger, be sure to calculate the net effect on your take-home pay.

You may lose momentum. Due to your reduced take-home pay, you may need to reduce the amount of contributions to your account while your loan is outstanding, depending on your disposable income. In addition, although not common, some plan loan policies won’t let you make additional contributions to your account until your loan is paid in full, essentially causing you to put your retirement investment progress on hold.

  • The money you withdraw will not grow if it isn’t invested.
  • Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.

You might face additional taxes. If you lose or leave your job before your loan is paid off, you may be on the hook to pay the loan back in full in a short time period, or it will be treated as a distribution and taxed accordingly. This is referred to as a loan offset. The outstanding amount may be subject to federal and, if applicable, state income taxes, as well as an additional 10% federal income tax for early withdrawal if you’re under age 59½, unless an exception applies. However, you may avoid this tax treatment by repaying or rolling over the unpaid loan amount to a new employer's 401(k) plan or an IRA, as long as this is done by the federal income tax filing deadline, including extensions, for the year in which the offset occurred.

You could miss out on valuable compounding time. When it comes to investing for a long-term goal like retirement, time can be money. That’s because of compounding — the ability to potentially earn money on your money. With compounding, the money you invest has the potential to grow, and those earnings may also grow. When you take your money out of the market, you might miss out on valuable “money earning money” compounding time.

How plan loans work

Many retirement plans allow you to take a loan up to (1) the greater of $10,000 or half of your vested account balance or (2) $50,000 minus any outstanding loan balances* — whichever is less. A general purpose loan must be repaid within five years, or it will be treated as a taxable distribution. However, a loan used to purchase your primary residence can be paid back over a longer period of time without being treated as a taxable distribution.

* The outstanding loan balance is determined as the excess of the highest outstanding loan balance for the participant in the 12-month period preceding the date the participant initiates any new loan over the outstanding loan balance on the date of the new loan. Check your employer’s 401(k) plan rules for details specific to your plan.

When it might make sense to take out a retirement plan loan

Some experts say that you should never take a loan from your retirement account, because of its potential to derail your retirement investment progress. Yet the truth is that there are a few circumstances when you may want to consider it.

You need fast access to cash. If you’re in an emergency situation and need money immediately — say, to repair your home after a natural disaster or to deal with an unforeseen medical situation — a loan from your retirement account might be a viable option.

It makes financial sense for your situation. In some cases, a plan loan, even with all its potential drawbacks, might help you get out of a bad financial situation. For instance, you may be able to pay off a high-interest credit card. You will generally be charged an interest rate similar to the rate you would pay for a bank loan, there is no credit check, and you pay the interest to yourself rather than to a bank or credit card company.

You need it to make a down payment on a home. If you’re considering purchasing a home, a higher down payment could lower the interest rate on your mortgage in some cases. Just remember that if you take out a loan from other lending sources, the interest typically will be tax-deductible. That’s not the case with a retirement plan loan.

Explore other options

Before you consider taking a loan from your retirement account, make sure you’ve exhausted other available options. Not sure where to start? A financial professional and/or tax advisor can help you explore other avenues for loans.

One way to avoid dipping into your retirement account prematurely is to start an emergency fund. By putting aside a little money every month, you’ll have a source of ready cash the next time an unexpected expense crops up.

Whatever you do, don’t let your short-term needs derail your long-term goals. By not tapping into your retirement account now, you may be better prepared to fund your future, whatever it may hold.

Merrill, its affiliates, and financial advisors do not provide legal, tax, or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Learn more and take action

  • If your employer’s 401(k) plan is with Merrill and you have questions or need help evaluating a loan, use the Benefits OnLine® app or visit Benefits OnLine®.
  • Learn more about 401(k) plan account loans.