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 out 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 is traditionally the lesser of $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.

Under the CARES Act, the IRS increased the dollar limit on 401(k) loans made between March 27 and Sept. 22, 2020, from $50,000 to $100,000 for individuals whose health or finances were impacted by COVID-19.

Repaying the 401(k) Loan

You should make payments at least quarterly, but commonly, this interval is manageable as you'll repay your loan through payroll deductions. The longest repayment term allowed is five years, though there are exceptions. Some 401(k) plans do not allow you to contribute to the plan for a certain period after you take out a loan.

Per the CARES Act, 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 in full, or risk having it be categorized as an early distribution—resulting in both 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 (for example, the prime rate + 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 allow for multiple loans, while others do 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 out a new 401(k) loan unless your plan specifically allows for it. 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

These loans are frequently used to repay debts or home repairs or improvements. Other major uses include buying or refinancing homes, buying automobiles, and paying for college tuition, medical costs, and vacation or wedding expenses.

Taking out a 401(k) loan to repay debt may be unwise, as your 401(k) assets are protected from creditors generally. 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. Specifically, 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 59.5 years old, a 10% early withdrawal penalty tax will also apply.

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. However, you can avoid taking the tax hit by rolling over the outstanding balance into an IRA or another eligible retirement plan by the due date (after extensions) for filing your federal income tax return for the year in which the loan was characterized as a distribution.

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