401(k) Loans and Related Rules to Know

Jul 10

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At some point in your life, you’ll need to borrow money. Whether for a new home, college tuition, medical bills, or even launching a new business, the need for extra cash will inevitably arise. The good news is that you can choose from several lending options, borrowing from banks, credit unions, credit cards, peer-to-peer lending platforms, family, or friends.

One additional option is borrowing money from your 401(k). Before you take the plunge, however, it’s important to learn how 401(k) loans work and the pros/cons of borrowing against your 401(k)—which is precisely what we’ll cover in this post.

Identifying if you have a 401(k) loan option

As a first step, find out if you can even borrow from your 401(k)—knowing this is a possibility with over 90% of plans—and then ask your plan administrator for application details. While most employers also allow you to borrow from your 401(k) for any reason, it’s best to check with your HR department for specifics regarding your individual plan.

How much you can borrow from your 401(k)

By law, the maximum loan amount you can borrow is generally 50% of your vested account balance or $50,000 (whichever is less). If your vested balance is $50,000, for example, you can borrow up to $25,000.

Pros of borrowing from a 401(k)

As with any other type of debt, taking out a 401(k) loan offers some advantages. These include:

· Convenience: A quick phone call (or few website clicks) is often all that’s needed to receive funds within a few days—depending on your plan administrator. Many companies are also beginning to offer a 401(k) debit card that, when used, deducts money directly from your account. Loan payments are also typically deducted from your paycheck, making repayment easy.

· No credit reporting: A credit check isn’t required when applying given the lack of underwriting, and a 401(k) loan won’t appear as debt on your credit report. You also won’t damage your credit score if you miss a payment or default on your loan.

· Low interest rates: The amount of interest you pay is set by your plan’s administrator and based on prime (the interest rate banks use to charge customers with good credit). The 401(k) rate is typically lower than what you can obtain through alternative sources, making payments more affordable.

· Interest paid back: With a traditional loan, you pay interest to a financial institution. With a 401(k) loan, however, the interest you pay goes back into your account.

· Payment flexibility: You have five years to repay your loan (or up to 10 years when the money is used to purchase a principal residence) and face no prepayment penalties.

· Suspended and/or extended payments: If you’re in the armed forces, you may be able to suspend loan repayments and/or extend your term if you’re called up for active duty.

Cons of borrowing from a 401(k)

On the flip side, taking out a 401(k) loan also involves several risks. These include:

· Missed investment growth: When you take out a 401(k) loan, that money is no longer invested; you may therefore potentially miss out on significant investment returns, especially during a bull market.

· If you leave your job, you’ll need to pay back your loan more quickly: Whether you leave your job voluntarily or otherwise, you may be required to pay back your loan within 60 days (check your specific plan rules just in case).

· Defaulting means potential taxes: If you can’t repay your loan, your unpaid loan balance is considered a “deemed distribution”: meaning your unpaid balance will get added to your gross income and you’d pay taxes on it for that same year. You may also be taxed by the IRS and assessed a 10% penalty.

· You may not get approved: Those nearing retirement may be considered “higher risk” and thus denied a 401(k) loan because payments will no longer automatically come out of their paychecks. Other reasons for a possible denial include exceeding your loan limit or if your reason for seeking the loan fails to meet plan criteria (e.g., you’re looking to finance your next vacation).

· 401(k)s from previous employers don’t count: Unless you rolled over money from previous 401(k)s, you can only borrow money from your current 401(k) plan.

· You may contribute less: After obtaining a 401(k) loan, it’s not uncommon for plan participants to scale back their contributions; some employers may not allow for contributions while participants have an outstanding loan, meaning you can also miss out on matching employer contributions.

· Fees may exist: In addition to interest, your employer may charge fees to apply along with a monthly (or annual) maintenance fee.

As you can see, borrowing from a 401(k) unfortunately has many drawbacks—which is precisely why you should only consider borrowing from your 401(k) as a last resort.

401(k) loan alternatives

In addition to your checking, savings, and brokerage accounts, you should consider 401(k) loan alternatives.

A home equity loan or line of credit are two low-cost options that can meet your cash needs, especially if you plan to use the funds to pay for much-needed home repairs. Plus, the interest is often tax-deductible in both cases.

Another option is to take out a personal loan, providing you with quick access to funds and the ability to use the money for any personal expense. As with any loan, shop around for the best deal if you decide to go this route.

You can also use a health savings account (HSA) to pay for qualified out-of-pocket healthcare expenses including deductibles and copays, specifically; if you need cash for a qualified medical expense, an HSA can help in this regard.

A low or zero-rate credit card may serve as a viable alternative as well, provided you can repay your balance within the promotional period—which typically ranges from six to 18 months, depending on the issuer.

In sum: is taking out a 401(k) loan a good idea?

Contemplating whether or not to take out a 401(k) loan is a decision to not take lightly, as the risks generally outweigh the benefits. However, that’s not to say this option never makes sense. If you know you’ll remain on track for retirement or need the money for a short-term expense (within a year), for example, a 401(k) loan is often the right move in this regard.

Want to know if a 401(k) loan is right for you? Schedule a FREE Discovery call with one of our CFP® professionals.

FAQs

The answer here depends on your specific plan’s rules—check with your administrator to learn if simultaneous loans are permitted.
Each 401(k) plan has different rules on 401(k) loans and withdrawals. That said, you must generally take out a second loan (if permitted) on your 401(k), roll over your plan into a new one (if changing jobs), or roll over your 401(k) into an IRA to gain access to additional funds.
With respect to either rollover option, so long as your loan repayment is in good standing, your employer will roll over your net retirement funds of the outstanding 401(k) loan (also known as a “loan offset”). If you successfully roll over this amount by the tax-filing deadline for the year in question, you can avoid paying income taxes and a 10% early withdrawal penalty on the rolled-over balance.
Taking money out of your 401(k) for what the IRS deems an “immediate and heavy financial need” is referred to as a “hardship withdrawal.” Such needs include avoiding foreclosure or eviction, repairing casualty losses to a principal residence (such as those from floods, earthquakes, or fires), home-buying expenses for a principal residence, burial or funeral expenses, up to 12 months’ worth of tuition and fees, and some medical expenses (know that your employer has discretion here in most situations).
Hardship withdrawals are generally more difficult to qualify for since you’ll need to prove you lack alternative funding options. However, unlike with a 401(k) loan, you don’t need to repay these funds (though you’re still required to pay taxes on them).