What you need to know about about taking out a 401(k) loan or making a hardship withdrawal

Sometimes life hurls a difficult, unexpected (and costly) event your way, and you find yourself wondering how you're going to pay for it. Hopefully you'd be able to rely on any money you set aside in an emergency fund to pay for your expenses, but if you don't have enough there (or any at all), you may be looking for an alternative solution.

If you have a 401(k) account through your employer, one option you may have available is taking out a 401(k) hardship loan or using a 401(k) hardship withdrawal to help fund some of those expenses.

However, it's important to note that before turning to a 401(k) loan, you should exhaust all your other options for extra money first. This means exploring any emergency money you may have set aside, dipping into any additional savings you have, or even seeing if it's possible to take on a side hustle that will cover the cost of what you need to pay for. This is because when you borrow from your retirement account, you're taking away the potential for that money to keep growing over time — especially if you withdraw your entire balance.

Here's what else you need to know about taking out a 401(k) loan or making a 401(k) hardship withdrawal.

A 401(k) loan lets you borrow money from your workplace retirement account on the condition that you pay back the amount you borrow with interest. The good news is that the payment amounts and the interest go right back into your account.

The interest rate you pay on a 401(k) loan can change over time. According to Debt.org, the interest rate you would pay on a 401(k) loan is usually a point or two above the lending rate used by banks. The rates used by banks is called the prime rate and it's influenced by the federal funds rate, so it can change over time. So if the prime rate is 5.2%, the interest rate you pay on your 401(k) loan may be around 6.2% to 7.2%.

Because your 401(k) is an employer-sponsored account, you'll need to abide by your employer's plan rules around taking out a 401(k) loan. Many employers have limits for how much of your balance you're allowed to borrow and how many loans you can take from your account per year — you'll need to double check the guidelines around your employer's plan before you take the next steps to borrow from your 401(k).

Keep in mind that if you were to leave your job before repaying a 401(k) loan in its entirety, you might have to repay the money you borrowed immediately (or at least over a much shorter period of time).

What about 401(k) hardship withdrawals?

401(k) loans are not to be confused with 401(k) hardship withdrawals. A hardship withdrawal isn't a loan and doesn't require you to pay back the amount you withdrew from your account. You'll pay income taxes when making a hardship withdrawal and potentially the 10% early withdrawal fee if you withdraw before age 59½. However, the 10% penalty can be waived if you can provide evidence that the money is being used for a qualified hardship, like medical expenses or if you have a permanent disability.

Another key difference between the two is that with 401(k) hardship withdrawals, you would be unable to pay yourself back what you took from your account. This is not the case with 401(k) loans.

The qualifications for a 401(k) hardship withdrawal depend on your plan and the rules of plan's administrator, so make sure to check to see how you can qualify for one.

Overall, you should only take on a loan from your 401(k) if you have exhausted all other funding options because taking money out of your 401(k) means you're hindering it from the most growth over time. You'll be missing out on the power of compound interest when you take money out of your retirement account.

If you need money to cover an expensive, unforeseen event that's leaving you feeling stressed, the first place you should look is your emergency fund. That's the purpose of your emergency fund, after all. It's typically recommended that you keep your emergency fund in a high-yield savings account — like the one from Ally Bank or Marcus by Goldman Sachs — since these typically earn more in interest compared to a traditional savings account.

If you don't have an emergency fund, you might consider turning to other non-retirement savings you have stashed away.

If this also isn't an option for you, you might then consider taking out a personal loan or using a credit card with a 0% intro APR period to fund your expense. These credit cards allow you to make purchases and pay them off with no interest for 12 to 21 months. This means you can save money on interest and pay back your balance over time. The actual 0% APR intro period will depend on the credit card you choose.

If the expense you're trying to cover is a medical expense, it could be a good idea to make a withdrawal from your Health Savings Account (HSA) if you have one. HSA's are an investment account that's meant for medical expenses. You make pre-tax contributions to the account, your balance grows tax-free and you also won't owe taxes when you make a withdrawal for qualified medical expenses. This is the triple tax benefit that comes out of this type of account, and it allows you to avoid going deeper into debt to pay for all or part of a medical expense.

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