If you have a 401 (k) plan through your employer and need funds, you may be able to take out a 401 (k) loan. Borrowing on your 401 (k) could pave the way for financial assistance without having to contact other lenders. However, there are also complex 401 (k) lending rules and potential drawbacks to be aware of.
To take out a 401 (k) loan, you will need to:
- Understand the 401 (k) lending rules.
- Know the benefits of a 401 (k) loan.
- Think about the downsides of a 401 (k) loan.
- Weigh your situation carefully before making a decision.
Read on to learn how the 401 (k) loan process works and how to decide if borrowing from a 401 (k) is right for you.
401 (k) Loan Rules
As the name suggests, a 401 (k) loan allows you to borrow money from your 401 (k) plan and pay it back over time with interest. “Every 401 (k) plan is different,” says Laura Morganelli, financial advisor at CAPTRUST in Allentown, PA. “The first step would be to determine what your plan allows.” Some plans offer a loan option, but others don’t, so check to see if a 401 (k) loan is allowed in your current plan.
The maximum 401 (k) loan amount is limited. “401 (k) loans are capped at 50% of your account value or $ 50,000, whichever is less,” says Ryan Shuchman, investment advisor and partner at Cornerstone Financial Services in Southfield, Michigan. If 50% of the acquired balance of the 401 (k) account is less than $ 10,000, the account owner can borrow up to $ 10,000, if the 401 (k) plan allows it.
The loan will come with interest that you will have to repay on your own, and you will usually have to repay the amount within five years. This may be different from other loans, like a mortgage, which can give you 10, 15, or 30 years to pay off the amount borrowed. Your monthly or quarterly loan payments will coincide with the five-year period. For example, if you take out a loan of $ 35,000 with an interest rate of 5%, your monthly payment could be $ 660. A longer repayment schedule may be allowed if the 401 (k) loan is used to purchase a primary residence.
If you are unable to repay the loan within five years, the unpaid amount will be considered a 401 (k) withdrawal from the account. “The balance then counts as ordinary income for taxes, plus a 10% penalty,” says Shuchman.
Benefits of 401 (k) loans
If you need access to funds, a 401 (k) loan may be preferable to an early 401 (k) withdrawal. “401 (k) loans can be a great alternative to withdrawing from a retirement account,” says Shuchman. “They are tax free and assets can be returned to the account without penalty to continue growing towards long term goals.” A withdrawal, on the other hand, will be subject to income tax. If you are under 59 1/2 you can also expect to pay a 10% penalty for a 401 (k) early withdrawal. And once you make a withdrawal, the funds will no longer have the ability to grow and earn interest.
Another benefit of a 401 (k) loan is the interest associated with the loan. “The interest paid on the loan is returned to your 401 (k) account,” Morganelli explains. If you take out a loan from another lender, the interest on loan repayments goes to the lender. Plus, with a 401 (k) loan, you usually don’t need to go through a credit check, which other lenders might require.
Cons of borrowing on your 401 (k)
Before taking out a 401 (k) loan, it can help to think about the long term situation. “Your 401 (k) is for retirement,” says Jason Parker, president of Parker Financial in Silverdale, Washington. If you withdraw funds from it, the account will not have as many years to earn interest. You may not be able to make additional contributions to the 401 (k) account until the loan is paid off, which means you could miss a 401 (k) match. If you have an emergency fund, it may be better to use those funds rather than the 401 (k) plan.
If you take out a 401 (k) loan and then quit your employer before repaying the amount, there could be negative consequences. “If you quit your job or are made redundant, the plan sponsor can demand that the loan be repaid immediately,” Parker says. “If you are unable to do so, it will be treated as a taxable distribution.” As such, you could lose your job and face a high tax event at the same time.
Deciding whether or not to take out a 401 (k) loan
If a loan option is available through your 401 (k) plan, you will be able to repay the loan within five years and you do not plan to leave your workplace, a 401 (k) loan could work. “The benefit of a 401 (k) loan is the ability to access your retirement funds for short-term cash flow in a tax-free manner, provided you repay the funds on a timely basis,” says Kenny Senour, a financial planner with Millennial Wealth Management in the Denver area.
However, if you have other options to pursue, it may be best to leave the funds in your 401 (k) account. “By tapping into even a small portion of your retirement nest egg early, you run the risk of derailing the progress you’ve made in retirement savings in addition to the penalties and taxes incurred if a loan is not repaid, ”Senour said.