If you contribute to a 401k plan through your employer, it could be one of your most substantial assets besides your home. And if money is tight and your savings account balance is running low, you might think about how you can tap into the funds in your 401k. But you know there must be both pros and cons of doing so.
Borrowing from your 401k is essentially borrowing money from yourself, but there’s much more to it than that. So, before you decide to take out a 401k loan, weigh your options and determine if it’s really worth it.
What is a 401k loan?*
A 401k loan is money you borrow directly from your 401k account balance. You then repay the loan, with interest, directly back to yourself and into your 401k account. Your exact repayment plan is dependent on how much you borrow and your 401k plan’s interest rate.
Note: A 401k loan is different from withdrawing money from your 401k account. When you withdraw money from your 401k account, it is subject to taxation. Also if you are under the age of 59½, you will pay a 10% penalty for early withdrawal (there are a few exceptions related to hardship).
How much can you borrow with a 401k loan?
Though a 401k loan seems straightforward, when it comes to how much you can borrow, things get a little more complicated. It depends on whether or not you have had an outstanding 401k loan balance in the last 12 months.
If you haven’t had a 401k loan balance for 12 months. In this case, the rules for borrowing are pretty clear: You are allowed to borrow up to 50% of your vested 401k balance, or $50,000, whichever is less.
- You have $120,000 in your account; you can borrow up to $50,000.
- You have $70,000 in your account; you can borrow up to $35,000.
If you’ve had an outstanding 401k loan balance in the last 12 months. In this situation, things get a little more tricky. You use the same rules as stated above, but reduce the amount you are allowed to borrow by the largest 401k loan balance you’ve had over the last 12 months.
- You have $120,000 vested in your 401k account and your largest 401k loan balance in the last 12 months was $10,000; then you can borrow up to $40,000 ($50,000-$10,000).
- You have $70,000 in your account and your largest 401k loan balance in the last 12 months was $5000; then you can borrow up to $30,000 ($35,000-$5000).
What is the interest rate on a 401k loan?
The interest rate is commonly 1-2% more than the prime rate. That being said, the actual interest rate you’re charged is dependent on your specific 401k plan.
What are the terms for repayment of a 401k loan?
Most 401k loans are due within five years, but it depends on your specific plan. Some plans make exceptions and extend the terms to 10 or more years for home purchases.
Note: The term of the loan is only applicable if you stay with the employer that sponsors the 401k plan you borrowed against. Here’s one of the most significant risks associated with taking out a 401k loan: if your job is terminated (for whatever reason) with the employer who sponsors the 401k plan you borrowed against, the loan is due within 60 days. If you do not repay it within the 60 days, the loan defaults.
What can 401k loans be used for?
Most plans do not place restrictions on what the loan can be used for. That being said, some plans only lend money if you use it for specific reasons, such as education, a first-time home purchase, or medical expenses.
What happens if your 401k loan defaults?
Your 401k loan will go into default if you fail to make payments, or otherwise, do not comply with the specific terms of your loan. This also means that, if you lose or quit your job, and you do not repay the loan amount within 60 days, your loan will default.
When you default on a 401k loan, the money you borrowed is then considered a distribution from your 401k account. If it is counted as a distribution:
- you will pay taxes on it
- if you are younger than 59½, you will pay a 10% penalty
- you will not be able to use the borrowed funds to roll over into an IRA
If you default on a 401k loan, it is not reported to the credit bureaus and will not negatively affect your credit score. But that doesn’t mean it can’t have negative consequences. Some lenders will ask specifically about 401k loan defaults, and this could still affect your ability to get a loan.
How do you get a 401k loan?
Unlike most other loan applications, borrowing from your 401k is relatively simple and straightforward – and your credit score isn’t required for this type of loan. Most Human Resources departments can provide the paperwork you need to apply for the loan.
Pros and Cons of getting a 401k loan
- No credit check to qualify
- Easy loan application process with minimal paperwork
- Access the money quickly
- Not reported to credit bureaus (which means, it does not boost your credit score as you pay it off, but it also doesn’t affect your credit score if you default)
- Interest payments are made back to your account
- The significant risk associated with a default (10% penalty & taxation)
- Loan due in full within 60 days of termination of employment
- Missed investment returns while money is not in the 401k
- Administration fees
- Loan payments are not considered 401k contributions
- Some employers will not allow you to make additional 401k contributions while you are repaying a loan
- Repaying a 401k loan does not increase your credit score
- The interest portion of the repayment is taxed
- Lost retirement savings
Are you thinking about a 401k loan? Keep in mind, while certain circumstances may make you consider it, you shouldn’t rely on your 401k for unexpected or unplanned expenses. That’s what emergency funds are for.
Before you take that leap, remember your 401k may be your only retirement savings. Most people don’t have pensions anymore, so many will rely on the money saved in the 401k to get them by in retirement.
*Not all 401k plans are created equal. Each plan has its own set of rules and terms for a 401k loan – and some don’t allow them at all. Contact your Human Resources department and consult your plan description to see your specific options.
Article written by Amanda