Can You Pay Off a 401(k) Loan Early?

You borrowed a few thousand dollars from your 401(k) some years ago to cover an emergency expense. By some luck, you're now liquid enough to pay the loan off early. Can it be done? Is it worth paying off your 401(k) loan early, or are there potential downsides?

The answers to these questions are subjective and depend on what plan your employer has set up. Below, you'll find a detailed guide to help you determine the best time to repay your 401(k) loan.

For starters, yes, you can repay a 401(k) loan early with zero penalties. Typically, loans are repaid through regular payroll deductions. You can either increase these deductions to pay off your loan sooner than the IRS's five-year requirement or, if you have the funds, pay off your outstanding balance in full.

Keep in mind that your 401(k) is an investment. The more money you have in it, the more savings you can grow to fund the retirement of your dreams. This is called compounding. By repaying early, you give additional money more time to grow in your 401(k), guaranteeing that your retirement plan can fully finance your retirement plans.

In addition, if your employer has set up a Roth 401(k), no further tax is deducted when you take aqualified "distribution" (the IRS term for "withdrawal") as all your contributions are made from post-tax income. This makes maximizing your investment more beneficial because, at retirement, all the money will be yours tax-free.

Another reason why you may want to pay off your loan early is occupational mobility. New tax laws dictate that if you change jobs, you'll only have until the due date of your next federal income tax return to repay your outstanding balance. If you're planning to switch jobs, early repayment helps you avoid this time crunch.

Finally, if you fail to pay off your 401(k) loan on time, it will be treated as an early withdrawal. You'll be charged all applicable taxes and penalties, regardless of who may be responsible for the delay. Paying off your loan early eliminates this risk entirely.

There are virtually no downsides to repaying your loan early. However, it's important to note that 401(k) loans are not reported to credit bureaus. Hence, when you pay them off is not a major concern since they have zero impact on your credit score.

You might be considering early repayment for fear of high interest rates. Again, your 401(k) is an investment that belongs to you. Any interest you pay goes back into your account directly. So if you pay $1000 in interest, every dollar still goes back to you.

A word of caution: the last thing you want is to rob Peter to pay Paul. If you can't afford to pay off your loan early, don't drain your savings or risk bankruptcy just to do so. Instead, stick to your regular payment plan.

Paying off your 401(k) loan may seem straightforward, but keep in mind that every plan has its own structure and set of rules. There are multiple considerations and without the right guidance, you could end up with unwanted tax burdens and wasted growth potential.

Speaking to a financial advisor will help you understand the repayment structure of your 401(k) plan and explore the safest repayment options available to you. So, if you want professional guidance on your 401(k) loan repayment and retirement planning,book a free consultation with us today.