How Does a 401(k) Loan Work?
401(k) loans provide an opportunity to access your retirement funds in times of financial emergencies. However, before you decide to borrow, you must fully understand the process and potential implications. Here are key things you need to know about 401(k) loans before taking one.
What Are the Limits on 401(k) Loans?
Your 401(k) accounts are subject to legal loan limits. The maximum amount you can borrow is usually the lesser of $50,000 or 50% of your vested account balance, whichever is lower. Your vested account balance is the amount that belongs to you. If your company matches some of your contributions, you may need to stay with the employer for a certain period before the employer’s contributions become yours. Your 401(k) plan may also require a minimum loan amount.
Repaying a 401(k) Loan
You must make repayments at least quarterly, but this schedule is generally manageable as you will repay the loan through payroll deductions. The longest repayment term allowed is five years, although exceptions exist. Some 401(k) plans do not allow you to contribute to the plan for a certain period after taking the loan.
Interest Payments
You will pay interest to yourself. The interest rate on your 401(k) loan is determined according to the rules of your 401(k) plan, but it is usually set as a formula (e.g., prime rate plus 1%). While you will be paying interest to yourself, taking out a 401(k) loan typically impacts your future retirement savings.
Warnings About Borrowing from Your 401(k) Account
Some 401(k) plans allow money to be withdrawn as a loan, but others do not. You should check with your 401(k) plan administrator or investment company to find out if your plan permits borrowing from your account balance. You can typically find their contact information on your statement. Some companies allow multiple loans.
Borrowing from a Former 401(k) Account
If you are no longer employed by the company that has your 401(k) plan, you may not be able to take out a new loan from your 401(k) account unless your plan explicitly allows it. You can transfer the balance from your former employer to your new 401(k) plan, and if your current employer’s plan allows loans, you can borrow from there. If you transfer your old 401(k) to an IRA, you will not be able to borrow from the IRA. It’s best to know all the rules before withdrawing or transferring your old 401(k) plan.
Using Your 401(k) Loan Wisely
These loans are often used to pay off debts or make repairs or improvements to homes. Other major uses include purchasing or refinancing homes, buying cars, paying for college expenses, medical costs, vacation costs, or wedding expenses.
Late Repayment Can Cost You Dearly
When you take a 401(k) loan, you do not pay any taxes on the amount received. However, if you do not repay the loan on time, there may be taxes and penalties due. Specifically, if the loan is not repaid according to the established repayment terms, any remaining loan balance can be considered a distribution. In this case, it becomes taxable income for you, and if you have not yet reached the age of 59 and a half, a 10% early withdrawal penalty will also apply.
Frequently Asked Questions (FAQs)
Is a 401(k) loan considered taxable income?
The remaining loan balance is considered a distribution if you leave your job while a 401(k) loan is outstanding, unless you repay it. You can avoid taxes by rolling the remaining balance into an IRA or another qualified retirement plan by the deadline (after extensions) for filing your federal income tax return for the year the loan was classified as a distribution.
What
Is a hardship withdrawal from a 401(k) difficult?
A hardship withdrawal from a 401(k) account may be an alternative to using a loan, depending on the reason you need the money, but it may not be the ideal option. You will be subject to a 10% tax penalty if you are under the age of 59 and a half, and the definition of what qualifies as hardship depends on your specific employer. Your employer may also prevent you from making any contributions for a period of time after taking the withdrawal.
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Sources:
– Internal Revenue Service. “Retirement Topics – Plan Loans.”
– Internal Revenue Service. “401(k) Loans, Hardship Withdrawals and Other Important Considerations.”
– Charles Schwab. “The Charles Schwab Guide to Finances After Fifty: Does It Make Sense to Borrow From My 401(k) if I Need Cash?”
– Maxwell Locke & Ritter. “Options for Your 401(K) Plan at a Former Employer.”
– IRS. “Retirement Plans FAQs Regarding Loans.”
– The Pension Research Council at the Wharton School. “Financial Literacy and 401(k) Loans.” Page 71.
– Internal Revenue Service. “Retirement Topics – Bankruptcy of Employer.”
– FINRA. “401(k) Loans, Hardship Withdrawals and Other Important Considerations.”
Source: https://www.thebalancemoney.com/facts-about-401k-loans-2388811
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