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Failing to repay a 401(k) loan could have big consequences. Read on to learn more.
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If you have a need for money, there are different options you could look at. You could apply for a personal loan or tap the equity you have in your home. But if you have money sitting in a retirement plan, you may decide you’d rather borrow against your own savings.
While you generally cannot borrow money from an IRA account, if you have a 401(k), your plan might allow you to take out a loan. And you might prefer to go that route because that way, you’re paying yourself back rather than repaying a lender.
As of the fourth quarter of 2022, an estimated 16.7% of 401(k) plan participants had an outstanding loan, according to Fidelity. So if you decide to borrow from your 401(k), you’ll be in good company. But that’s not necessarily the right move, because if you don’t repay your 401(k) loan, the consequences could be quite unfavorable.
You could end up with a penalty on your hands
If you fail to repay your 401(k) loan, it will be treated as a distribution from your plan. And the consequences there will depend on your age.
If you’re not yet 59 1/2, you’ll face an early withdrawal penalty equal to 10% of the sum you borrowed. And regardless of your age, if you have a traditional 401(k) plan, not a Roth, you’ll be taxed on the money you borrowed since it will be considered a distribution.
That tax isn’t a penalty. That’s just how traditional 401(k)s work — withdrawals are subject to taxes because you get a tax break on your contributions. But either way, not repaying a 401(k) loan could end up being costly, so it’s a situation best avoided.
Also keep in mind that if you don’t repay a 401(k) loan, you’ll have that much less money left in your account for retirement itself. And at that stage of life, you’re apt to need that money the most.
There may be a better way to borrow money
It’s easy to see why taking out a 401(k) loan can be tempting. After all, if you have money that’s actually yours, why not do that instead of going through the process of applying for a loan elsewhere?
But borrowing against your 401(k) is risky because there’s a chance you might not be able to pay your loan back as expected. So it pays to consider other borrowing options that can be reasonably affordable, like taking out a personal loan or a home equity loan.
Granted, there can be consequences for not repaying these types of loans, too. If you fall behind on either, you risk damaging your credit score quite a bit. And in a more extreme scenario, not repaying a home equity loan could result in losing your home.
One major difference, though, is that if you sign one of these loans, you’ll have a preset repayment schedule to follow. With a 401(k) loan, the same thing will happen. But if you end up leaving your job (voluntarily or otherwise), your repayment window might be whittled down to just a few months, depending on the rules of your plan. And that specifically makes a 401(k) loan a more precarious borrowing option.
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