The Pros and Cons of 401(k) Loans and Hardship Withdrawals

Posted on Jan 9, 2023

Should employers allow employees to take loans or hardship withdrawals from their 401(k) accounts? While IRS rules leave it up to the employer to decide whether these options should be included in the plan, there are pros and cons to consider:

Pros:

• Employees may be more motivated to participate in the retirement plan if they know they can withdraw funds or take out a loan in an emergency.
• 401(k) loans don’t require a credit check, show up as debt, or impact an employee’s credit score.
• When employees experience an immediate and critical financial need for medical expenses, tuition payments, funeral expenses, costs related to the purchase or repair of a primary residence, or to avoid foreclosure, a loan or hardship withdrawal may be the best option if other alternatives do not exist.

On the other hand, both loans and hardship withdrawals have risks and potential tax consequences. For example, hardship distributions, which are not meant to be repaid, permanently reduce the employee’s account balance under the plan, depriving them of the benefits of long-term compound growth. Other cons include the following:

• Since loans are meant to be repaid, if the employee falls behind on payments or defaults on the loan, they’ll owe taxes on the outstanding balance, in addition to a 10 percent early withdrawal penalty depending on their age.
• If the employee leaves the company with an outstanding loan balance, the plan can require immediate repayment of the entire balance or it will be considered a distribution, with the ensuing tax obligation.
• Employees taking a hardship withdrawal must pay taxes on the amount they withdraw (unless withdrawn from Roth contributions) and incur possible penalties for early distribution unless they meet the IRS criteria for qualifying expenses.

Watch this video for more information on how participant loans and withdrawals can impact retirement outcomes.

This material is provided for informational purposes only, and is not intended as authoritative guidance, legal advice, or assurance of compliance with state and federal regulations.