There are times when life hands you lemons and you can make lemonade. But then there are times when your lemonade stand desperately needs a new roof, but you’re out of sugar. What do you do?
The good news: If you need extra cash for an emergency but your rainy-day fund won’t cut it, you may have options. If you have a 401(k) or similar workplace retirement plan, you may be able to borrow from the account, take out a personal loan, or even withdraw from the retirement account early. Here’s why two of those choices could be smart moves—but the third is one to avoid.
What is a retirement loan?
As the name suggests, a retirement loan is a loan you can take from your retirement savings, like a 401(k) account.
Unless you’re using a 401(k) loan to purchase your first home, you must repay what you borrow, with interest, within five years. (The money you borrow won’t keep growing tax-deferred until you pay it back, but the interest you’ll pay will at least prop up your account until you can get it fully growing again.)
Even so, only certain workplace retirement plans qualify for loans, including 401(k)s, 403(b)s, 457(b)s, profit-sharing plans, and “money purchase” pensions. On the other hand, you can’t borrow from individual retirement accounts (IRAs) or IRA-based plans like SEPs, SIMPLE IRAs, and SARSEPs.
Yet even if your retirement plan allows for loans, your employer may not. Verify with your benefits department or check your summary plan description (SPD) to learn your plan’s rules.
Also, consider loan limits: Per IRS rules, you can borrow only up to $50,000 or 50% of your vested balance, whichever is less.
For example, if you have $70,000 saved for retirement, you can borrow up to $35,000 (50% and under the $50,000 limit). But if you’ve amassed $110,000, your loan amount will be capped at $50,000. Also, if your account has less than $10,000, you may be able to borrow up to your entire balance, but plans don’t have to include this exception. Check with your benefits department for details on your plan.
Pros and cons of a 401(k) loan
- Quick distribution. You often can receive your full loan amount almost immediately after approval.
- No minimum credit score required. Most, if not all, private lenders require you to have a minimum credit score to be an eligible borrower. With a 401(k) loan, you don’t need to meet typical lender guidelines to qualify.
- No impact on credit. 401(k) loans don’t require a credit check, and credit bureaus don’t receive reports on payment activity related to retirement loans.
- No taxes or penalties. You can avoid taxes or early-withdrawal penalties if you repay your loan in five years.
- Automated repayment. Your employer deducts your required monthly installment from your paycheck.
401(k) loans do have disadvantages, though. Consider these carefully before making a decision:
- Plan restrictions. Your employer may not allow you to borrow from your 401(k).
- Borrowing limits. You can borrow only up to $50,000 or 50% of your account, whichever is less.
- Job changes may affect repayment. Your employer may require you to pay the remaining loan balance sooner—often immediately—if you leave a job. Failure to pay your outstanding balance could mean significant tax and early-withdrawal penalties.
- No bankruptcy protection. If you file for bankruptcy, the money you borrowed from a workplace plan no longer receives protection from creditors.
What is a personal loan?
If you don’t have a workplace retirement account to tap, or the pros and cons of a 401(k) loan don’t work for you, consider a personal loan.
Financial institutions like banks and brokerages offer these loans—money you borrow for personal reasons like paying off debt or financing a big purchase. You must repay this loan monthly with interest over a set timeframe.
There are two types of personal loans: secured and unsecured.
- Secured loans require you to put down collateral, such as your home or car. Because your property backs the loan, secured loans usually mean lower interest rates. The trade-off: If you fail to repay the loan, your lender can seize your collateral.
- Unsecured loans don’t require collateral. This makes them riskier for lenders to finance, so you’ll often see higher interest rates on these loans.
Shopping around for lenders online, using comparison tools, and improving your credit score can help you get the best rates on a personal loan. Additionally, getting a co-signer can increase the likelihood of approval and low interest rates.
Pros and cons of a personal loan
If you’re thinking about a personal loan, these are a few advantages you can expect:
- A lump-sum distribution. You can receive your full loan amount almost immediately after approval.
- Lower interest rates. Even unsecured personal loans tend to have significantly lower interest rates than other forms of debt, like credit cards and payday loans.
- Flexible terms. Repayment periods for personal loans are typically longer than short-term lines of credit, usually between 12 and 60 months.
- Use as a debt management tool. You can make debt payoff easier by consolidating high-interest debts into a personal loan for one monthly payment and a lower interest rate.
On the other hand, a personal loan can have its share of challenges. Among them:
- Eligibility rules. Most lenders require a minimum credit score, evidence of stable income, and a low debt-to-income ratio. If you fail to meet a lender’s requirements, you may need a co-signer to increase your chances of approval.
- Impact on your credit score. Lenders typically check at least one of your credit reports before approving or denying your application. This “hard” inquiry can ding your credit score. Worse, late or missed payments can significantly damage your score.
- Interest rates. With a personal loan, interest is built into your payments. By contrast, you owe interest on credit cards only if you don’t pay your balance in full every month.
- Increased debt. Though personal loans could be useful for debt consolidation—bundling debts together could cut your monthly bills and make repayment more manageable—this may be futile if you continue to rack up more debt.
Is a retirement loan or a personal loan better?
It can be difficult to choose between a retirement loan and a personal loan. So, consider each option’s long-term consequences, how close you are to retirement (when you’ll likely need your entire nest egg), and the loan’s eligibility requirements.
If you plan to retire soon (in five years or less), a 401(k) loan may not be the best option—you must repay the loan within that period to avoid penalties. In that case, a personal loan may be the better way to go.
In most circumstances, borrowing from a 401(k) should be a last resort. If you have a low credit score and can’t qualify for a personal loan, or you’ve already exhausted emergency savings, a retirement loan may be your best option.
How do retirement withdrawals work?
Instead of borrowing from your 401(k) (or taking a personal loan), you can withdraw money from your retirement account without paying it back. However, unless the move qualifies as a “hardship” withdrawal under your plan’s rules, you’ll face taxes, potential penalties, and maybe other consequences.
Withdrawal penalties differ slightly between workplace retirement accounts, like 401(k)s and individual accounts (like IRAs). The rules also differ between “traditional” pretax accounts and after-tax accounts (like Roth 401(k)s and IRAs).
If you cash out from a 401(k) before age 59½, you may have to pay taxes on the distribution amount plus a 10% early-withdrawal penalty.
Let’s walk through an example: Suppose you have $50,000 in a 401(k), you’re 35, in the 22% federal tax bracket, and you live in Idaho, which has a state income tax of 5.80%.
If you withdraw all those savings prematurely, you’ll owe $13,900 in federal and state taxes on top of a $5,000 IRS penalty. Result: You’ll have only $31,100 at your disposal—not to mention $50,000 not working for your future.
If you have a Roth IRA, however, your contributions comprise after-tax dollars. This means you can withdraw those contributions tax-free at any time. But if you’re under age 59½ and make that move, you’d owe tax on withdrawals that include earnings from investment gains, interest, dividends, or pretax matching contributions.
If you’re thinking of cashing out any retirement funds early, think twice—then think again because early withdrawals can significantly derail your retirement goals.
According to a recent survey for Prudential, 70% of Americans plan to retire but aren’t confident they’ll be able to. Draining even some of your retirement savings means your money will no longer benefit from potential growth, let alone basic compounding. That means you’d risk not having enough money to fund retirement.
Consider using a retirement calculator to determine how much you need to save and whether cashing out part of your savings will still allow you to retire the way you want.
Before you borrow from your workplace retirement account, take a personal loan, or completely cash out your retirement savings, consider the advantages and drawbacks of each move carefully. Assessing your unique needs and situation is vital to making the right decision for your financial situation. Start by tallying any savings you have, how great your need is, and your time until retirement.
You don’t have to do it alone, however. A Prudential financial professional can give you personalized guidance to help you make the most informed decision.
Author Details
Alani Asis is a freelance writer whose work has appeared in Forbes, Fortune, and Insider, among others.
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