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How Does a 401(K) Loan Work?

What is a 401(k) loan?

A 401(k) loan is a loan you take from your 401(k) retirement account. Most 401(k) plans allow employees and business owners to take loans from their 401(k) accounts if they find it challenging to save for retirement as well as keep money aside for unplanned expenses.

A loan from your 401(k) plan is not ‘free money,’ but it’s a quick way to get funds at a low-interest rate to help fund a big purchase or pay a lump sum as a down payment on a home.

The repayment plan is created depending on the amount you borrow, and the interest rate applied. Repayment (principal + interest) is usually made through automatic payroll deduction back into your 401(k) account.

401k Loan

Before you decide to borrow from your 401(k) plan, ensure that you understand the process and its potential implications.

Why do people take 401(k) loans?

If your 401(k) plan allows you to take a loan, you can borrow from your 401(k) for any reason. However, some plans allow you to borrow only for specific reasons. So, before trying to take a loan, check your plan’s rules.

Using a 401(k) loan for emergencies or for elective expenses like travel, weddings, etc. isn’t recommended. If you use the 401(k) loan for a good reason, it may even help you in the long run. For example, if you take a 401(k) loan to pay off your high-interest credit card debt, you could save money in interest than you would usually pay to your credit card lenders. It is interesting to note that 401(k) loans do not check your credit score, nor they reflect on your credit report as debt.

Another example is using a 401(k) loan to fund major home repairs or home improvement projects that increase the property value, which is good enough to compensate for the fact that you now have reduced retirement savings and would be repaying the loan with after-tax money.

401(k) loan can be used for various purposes, including

  • Paying off high-interest debt
  • Financing a down payment on a house
  • Paying back taxes, or money owed to the IRS
  • Covering medical expenses
  • Financing necessary home repairs
  • Paying education expenses

When can you take out a loan from 401(k)?

When you find it a challenge to find liquid cash for serious short-term (a year or less) financial need, getting a loan from your 401(k) plan is a good idea.

Your serious liquidity need could be a one-time demand for funds or a lump sum cash payment required to tide over a crisis situation, like the coronavirus outbreak that has disrupted your regular income flow.

How much can you borrow from 401(k)?

Determining how much you should borrow from your 401(k) can be a little tricky process. Here’s a quick summary.

If within the last 12 months, you haven’t had any outstanding 401(k) loan balance, you are eligible to borrow:

  • 100% of your vested 401(k) balance, up to a maximum of $100,000. The Cares Act recently changed the rules.

But, it isn’t as simple as it sounds.

  • If you have had an outstanding 401(k) balance within the past 12 months, you can borrow up to the largest balance you’ve had during that period.

Borrowing from an old 401(k)

If you are not working with the employer with whom you had the 401(k) plan, you may not be eligible to take a 401(k) loan. In this case, you can transfer the balance from your old 401(k) plan to your new 401(k) plan. If your current employer allows you to take 401(k) loans, you may take the loan. However, if your transfer your old 401(k) to an IRA, you will not be able to borrow from the IRA.

Before you transfer your old 401(k) plan to a new plan, ensure that you are well aware of the rules governing the transfer.

401K loan Rules

  • Each loan has to be established under a written loan agreement.
  • The business owner has to set a commercially reasonable interest rate for plan loans.
  • The borrowed amount cannot exceed the maximum permitted amount.
  • The loan has to be repaid within 5 years unless it is used to purchase a principal residence.
  • Loan repayments must include principal and interest and have to be made at least quarterly.

How does 401(K) loan work?

The loan application process is as follows:

  • Submit a request for a 401(k) loan, either online or through your HR department.
  • Indicate the account to the plan administrator from which you want to borrow the money from.
  • Investments are liquidated upon receiving your request.
  • You will lose any gains that your investments would have made during the loan period.
  • Depending on the type of plan you have, you may or may not be allowed to continue making pre-tax contributions.

Since there is no credit check for 401(k) loans, it is easier to get these loans compared to the other types of loans. And since 401(k) plan loans are available to all employees in the company, you should get your loan approved, regardless of the position you hold in the company.

401(k) Loans: Interest Rates, Taxes, and Fees

  • Interest rates on 401(K) loan

A 401(k) loan is not free money. Like any other loan, it comes with interest. Usually, the interest rate on 401(k) loans is a point or two above the prime rate. Currently, the prime rate stands at 5.5%. This means your 401(k) loan rate will have an interest rate that ranges between 6.5% and 7.5%.

In a 401(k) loan, you are paying interest to yourself, and not to your bank or your employer.
When you are taking a 401(k) loan, you are not just transferring money from one pocket to another – it’s not that simple.

Your money in your 401(k) usually sits safely in your account and grows by accruing compound interest. Simply put, compound interest means earning interest on the interest your earned. This means that your money in a 401(k) grows at an ever-accelerating rate. But, if you withdraw money from your 401(k), you will have a reduced amount to take the benefit of the compound effect.

So, when you repay the borrowed amount with interest, you are actually allowing your retirement account to stay on track. By the time you fully repay the loan with interest, you would have an amount almost around the same amount you would have accumulated if you had let the money stayed in your account untouched. The only difference here is that you have to pay extra from your pocket instead of sitting back and letting your nest egg grow in the account.

  • Tax implications when you borrow from your 401(k)

The beauty of a typical 401(k) is that it allows you to put away untaxed money. The money will be taxed only when you start withdrawing from it in retirement. Since most of us will have lower incomes in retirement, we will be in lower tax brackets.

Now, if you take a loan from the 401(k) plan, you will face major tax implications. You will be taxed on the interest you pay to yourself, and furthermore, you’ll also be taxed on the amount you withdraw in retirement. This is called double taxation, and it’s completely legal.

If you lose or leave your job before you repay the 401(k) loan, the IRS expects you to repay the full loan amount by the next tax year. For instance, if you leave your job in the spring of 2020, you’ll have to repay the entirety of the loan by April 15, 2021.

However, if you get a new job and transfer your old 401(k) loan to your new account, you may be able to stave off the IRS for a while.

  • Fees applied when you take a 401(k) loan

You may have to pay origination fees that range from $50-$100. Some 401(k) loans may also charge maintenance fees that can be anything between $25 to $50. If the loan is large, you may shrug off these fees, but if you are borrowing a small amount of $1,000, for example, you will be paying almost 15% of the borrowed amount as fees.

The 401(k) loan has to be repaid within 5 years; otherwise, the IRS considers the loan as a “deemed” distribution for which you are liable to pay an income tax, plus an early withdrawal penalty of 10% of the borrowed amount if you are younger than 591/2.

Pros – Reasons to borrow from your 401(k)

  • With a traditional loan from a bank, you pay interest on the loan to the bank. However, with a 401(k) loan, you pay interest to yourself, back into your 401(k) account.
  • The interest rate on a 401(k) loan is usually lower than other types of loans, thus making repayments affordable.
  • No qualifying requirements like credit score are needed to take a 401(k) loan.
  • If you are taking the 401(k) loan to buy a home, you can repay it within 10 years.
  • Repayments are consistent and easy since they are directly debited from your paycheck.
  • If you are in the armed forces, you can suspend your loan repayments while on active duty, however, this may extend your loan tenure.

Cons – Possible consequences if you borrow from your 401(k)

  • The money you borrow from your account will not be invested until you repay it. This means if your investment gains are greater than the interest you pay on loan, you are missing out on the investment growth.
  • If you have taken the loan to pay off your debts or meet your living expenses, you may not have the financial bandwidth to repay the loan while you continue saving for retirement.
  • If you leave or lose your job, you may have to repay the outstanding loan within 60 days or a year.
  • If you fail to repay the loan, your loan will be treated as a taxable distribution. You will also attract a 10% early withdrawal penalty (if you are younger than age 59½).

Repaying the 401(k) Loan

You have up to five years to repay a 401(k) loan. However, if the loan is taken to buy a principal place of residence, the repayment tenure may be up to 15 years.

The IRS wants you to repay the loan in “substantially equal payments that include principal and interest and that are paid at least quarterly.” Your plan may directly deduct the repayment amount from your payroll.

No early repayment penalty is applied.

What happens if you default on the loan?

When you default on a 401(k) loan, the remaining loan balance is counted as a “deemed” distribution from your 401(k). That has two big consequences:

  • The loan amount is considered a distribution and will be taxed. Also, you will have to pay a 10% early withdrawal penalty if you are younger than age 591/2.
  • You cannot roll over the defaulted amount into an IRA or any other employer retirement plan. This means there is no way you can avoid taxes and penalties.

However, the good news is that your default is not reported to the credit bureaus and hence will not affect your credit score.

What is a 401(k) hardship withdrawal?

A 401(K) hardship withdrawal is an emergency withdrawal from a retirement plan.

The IRS says, “a hardship withdrawal must be made on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need.”
The following conditions are eligible for a hardship withdrawal:

  • Certain medical expenses
  • Buying a principal residence
  • Tuition and fees
  • Expenses to prevent being evicted or foreclosed
  • Funeral or burial expenses
  • Certain expenses to repair the damage caused to principal residence due to floods, earthquakes, and fires

Unlike a 401(k) loan, the funds taken under hardship withdrawal needn’t be repaid. However, you will need to pay the taxes on the amount you withdraw. When you make the withdrawal, 20% of it will be withheld to cover your federal taxes.

If you’re under 59½, a 10% penalty will be applied, unless you meet strict standards laid down by the IRS for early distribution.

If you have other assets or insurance that can cover your financial needs, you will not qualify for a hardship withdrawal.