What You Need to Know About 401(k) Loans Before You Take One

How Does a 401(k) Loan Work?

Quick facts about borrowing from your 401(k). The maximum amount you can borrow will be $50,000 or 50% of your vested account balance, whichever is less. Repayments will be automatically taken from your paycheck after taxes. Some plans do not allow you to contribute to the plan while you are making loan repayments. Borrowing rules depend on company—some allow it, some don't. And if you don't repay a loan on time, you might owe taxes and penalties.

Image by Madelyn Goodnight © The Balance 2020

Borrowing from your 401(k) isn't the best idea—especially if you don't have any other savings put toward your retirement years—however, when it comes to a financial emergency, your 401(k) can offer loan terms that you won't be able to find at any bank. Before you decide to borrow, make sure you fully understand the process and potential ramifications. Below are seven things you need to know about 401(k) loans before you take one.

What Are the 401(k) Loan Limits?

Your 401(k) is subject to legal loan limits set by law. The maximum amount you can borrow will be $50,000 or 50% of your vested account balance, whichever is less. Your vested account balance is the amount that belongs to you. If your company matches some of your contributions, you may have to stay with your employer for a set amount of time before the employer contributions belong to you. Your 401(k) plan may also require a minimum loan amount.

The IRS announced that the dollar limit on 401(k) loan made between March 27 and Sept. 22, 2020, is increased from $50,000 to $100,000.

Repaying the 401(k) Loan

Your loan must be repaid through payroll deductions, and repayments will be automatically taken from your paycheck after taxes. The longest repayment term allowed is five years, though there are exceptions. Most repayment plans are structured as monthly or quarterly payments, and some 401(k) plans do not allow you to contribute to the plan while you are making loan repayments.

The IRS announced that plans may suspend loan repayments that are due from March 27, through Dec. 31, 2020.

If you lose your job while you have an outstanding 401(k) loan, you may need to repay the balance quickly, or risk having it be categorized as an early distribution—resulting in taxes owed and a penalty from the IRS.

Interest Payments

You will pay yourself interest. The interest rate on your 401(k) loan is determined by the rules in your 401(k) plan, but it is typically set up as a formula, such as "Prime + 1%." Although you pay the interest back to yourself, taking a 401(k) loan hurts your future retirement savings most of the time.

Caveats to Borrowing From Your 401(k)

Some 401(k) plans allow a withdrawal in the form of a loan, but some do not. You must check with your 401(k) plan administrator or investment company to find out if your plan allows you to borrow against your account balance. You can usually find their contact information on your statement.

Some companies may also allow multiple loans, while others will not.

When your employer set up the 401(k) plan, they decided whether the plan would allow loans or not. 

Borrowing From an Old 401(k)

If you are no longer working for the company where your 401(k) plan resides, you may not take a 401(k) loan. You may transfer the balance from a former employer to your new 401(k) plan, and if your current employer plan allows for loans, then you can borrow from there. If you transfer your old 401(k) to an IRA, you cannot borrow from the IRA. It is best to know all the rules before you cash out or transfer an old 401(k) plan.

Using Your 401(k) Loan Wisely

Research on 401(k) loans and defaults shows 39% of loans are used to repay debts, and 32% are used for home repairs or improvements. Other major uses included automobiles, college tuition, medical costs, and vacation or wedding expenses.

Taking out a loan to repay debt is dangerous, as your 401(k) assets are protected from creditors. In addition to the initial balance hit, money removed from your 401(k) will miss out on potential market gains

Late Repayment Is Potentially Costly

At the time you take a 401(k) loan, you pay no taxes on the amount received. However, if you don't repay the loan on time, taxes and penalties may be due. If you leave employment while you have an outstanding 401(k) loan, your remaining loan balance is considered a distribution at that time, unless you repay it. The 2018 Tax Credit and Jobs Act (TCJA) extended the repayment deadline from 60 days to the day your federal income tax return is due.

If the loan is not repaid according to the specific repayment terms, then any remaining outstanding loan balance can be considered a distribution. In that case, it becomes taxable income to you, and if you are not yet 59 ½ years old, a 10% early withdrawal penalty tax will also apply. About 10% of loans go into default due to a job change and not enough resources to satisfy the loan.

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