Is it better to borrow or withdraw from a 401(k)?

Generally, your 401(k) should be left alone to grow with your regular contributions. Recognizing that in times of financial trouble, you may need somewhere to turn, 401(k)s were built with some flexibility for taking money out through loans and withdrawals. 

Some 401(k) plans may allow loans, and some plans may even allow you to take out more than one loan. But loans come with interest and fees. 

When loans aren’t permitted—and even when they are—you may instead want to take a withdrawal from your plan, but withdrawals come with rules and penalties. 

So how do you know which way to turn when you really need cash?

401(k) loans and fees can affect retirement readiness

Some 401(k)s allow you to borrow money from your account. If they’re allowed, 401(k) loans have to be paid back within a certain amount of time, usually five years. And generally, you may borrow the lesser of $50,000 or 50% of your vested account balance, although your plan may have stricter rules. 

401(k) loans: the pros

• You pay yourself back, and you even pay yourself the loan interest. 
  
• There’s no income tax or penalty fee on the loan proceeds.
• Interest rates tend to be low, compared with a bank loan or credit card.
• There’s no credit check or minimum credit to qualify.
• There are no requirements or restrictions for how you spend the money.

401(k) loans: the cons

• Your plan may not permit loans.
• You lose the potential for investment gains on the money borrowed.
• There’s a limit to how much you can borrow.
• Your plan generally can only allow you to borrow for no more than five years.
• Your interest payments aren’t tax deductible.
• You may be charged loan processing and maintenance fees.
• If you leave your employer, you usually have to pay the entire loan off or default on your loan. 
• If you default on your loan, your unpaid balance is taken from your 401(k) and taxed as a distribution. In addition, if you’re younger than 59½, you’ll likely owe a 10% early withdrawal penalty. 

The bottom line on 401(k) loans: If you know you’ll be able to pay the loan back without defaulting, you may want to consider a loan. 

401(k) withdrawals may have hefty fees and penalties

No matter your age, you’re always going to have to pay income taxes when you withdraw pretax retirement savings. And if you make a withdrawal from your retirement account before age 59½, you’re also subject to a 10% early withdrawal penalty, unless you meet one of the exceptions provided by the IRS.

There are some exceptions to the 10% penalty before age 59½ for 401(k) and other qualified plans, including:

• Death
• Total and permanent disability
• Unreimbursed medical expenses that exceed a certain percentage of your adjusted gross income
• A series of substantially equal payments—you commit to taking payments for five years or until you reach age 59½, whichever comes second (payments must begin after separation from service in qualified plans)

The IRS website provides a complete list of exceptions. 

The bottom line on 401(k) withdrawals: If you qualify for an exemption from the 10% penalty, a withdrawal may make sense, although you should keep in mind that you'll owe income taxes on the amount you withdraw. If you don’t qualify for an exemption and you’re younger than 59½, consider how much you’ll owe in penalties and taxes before you take a withdrawal.