401k Loans 101

June 28, 2011

If you’ve been setting investing goals and decided your 401k was a good place to invest your money then you probably have some money built up in your retirement account.  What if you discover you need that money you’ve been putting aside before retirement?

You may be able to take a 401k loan, where you can borrow against the money you’ve accumulated in your retirement account.  If you find yourself in a tough situation where you need money quickly a 401k loan might be tempting but be aware there are some potential risks.  Today we’ll look at the pros and cons of a 401k loan and some frequently asked questions.

401k Loan Rules

How does a 401k loan work? Your best resource is your plan sponsor. Each employer-sponsored plan can be different, and your plan is not required to allow you to take a loan.

If your plan does allow you to borrow from your 401k plan, these rules apply:

  • you may only borrow a maximum of 50% of your vested account balance, with a cap of $50,000
  • unless you are buying a home, you must repay the loan within 5 years of borrowing the funds
  • you must make consistent payments (at minimum, one per quarter) until the debt is repaid

Upside to borrowing From Your 401k

It seems like a pretty good deal. You can borrow from yourself, and the interest you pay back on the loan goes back into your retirement pocket. You don’t end up losing money by paying interest to a bank or credit card. The interest you pay goes from your checking account to your retirement account. It stays under your control. That is a major benefit of borrowing from your 401k plan.

A second benefit is no credit check is required. There are no qualifications set in place. You don’t have to have a certain credit score: the money is yours to borrow as needed.

Risks of Taking a 401k Loan

As nice as paying yourself interest sounds, there are some significant risks to consider with this type of borrowing. The first major concern is that any change in your job status normally means you must repay the loan within 60 days. That means if you lose your job or willingly leave the company, you must have funds available to repay the loan almost immediately. If you’ve just lost your job it might be difficult to repay the loan that fast.

If you can’t repay the loan, whether through job loss or not, your initial withdrawal of the funds will be treated as a taxable distribution. You will then owe income tax on the funds you borrowed plus a 10% fee to the IRS assuming you are under age 59 and a half. Even if you can eventually repay the loan, you will pay an origination fee and potentially a maintenance fee tacked on top of it. Your “free loan” to yourself probably won’t be exactly free.

Another risk is the potential loss of investment gain from removing funds from your portfolio. It would be great to avoid a market crash if you could time the market (something that is impossible to really do), but what if your portfolio grows 50% over that maximum 5 year loan period? The investment gains you leave behind can make other forms of borrowing look inexpensive in comparison.

An additional consideration is borrowing when times get tough sets up a bad habit of borrowing. When your expenses go up, your income goes down, or both, the last resort is to borrow money. A better course of action is to cut back on your expenses or find a way to increase your income again. Borrowing from your 401k is a risky, but easy “out” in this situation.

Alternatives to Borrowing From Your Retirement Plan

As mentioned above the best alternative to borrowing from your financial future is to cut back, sell items you own, or grow your income. Borrowing shouldn’t be your first option.

You could consider taking a home equity loan or utilizing a home equity line of credit, but in doing so you will be paying interest to the lender rather than to yourself. The upside to a HELOC over a 401k loan is the loan does not instantly become due if you change or lose your job.

In recent years a new credit market has emerged that offers person-to-person loans.  There are a few P2P lending companies like Lending Club and Prosper that let you apply for loans that are funded by a group of other people.  You still have to go through a loan application process and they evaluate your credit but the fees and rates can be less than going through a bank.

If you need money for a short period of time and don’t mind increasing your risk, you may be able to swing a 0% financing deal with a new credit card. Of course the credit card company is willing to take this risk on the assumption that you will slip up at some point in the future, and owe them a lot in fees and interest charges.

401k Loan Frequently Asked Questions

Q: How much can I borrow from my 401k?

A: Up to 50% of your total vested account balance to a maximum of $50,000. You could borrow $50,000 only if your account had at least $100,000 in it.

Q: Is borrowing from my 401k tax deductible?

A: No.

Q: How quickly do I have to repay the loan?

A: Within 5 years of borrowing unless you leave the company or lose your job. Your 401k loan cannot be rolled over to a new plan, and your loan may be due within 60 days of a job status change. (If you borrow to finance a home purchase, your terms can be longer — up to 15 years.)

Q: What fees will I incur with a 401k loan?

A: You will owe yourself interest, and pay an origination fee to the plan sponsor. You may also pay a maintenance fee. If you cannot repay the loan it will be treated as a non-qualified distribution and you will owe the IRS a 10% fee plus income tax on the amount borrowed.

Kevin

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Kevin

Kevin Mulligan is a debt reduction champion with a passion for teaching people how to budget and stay out of debt. He’s building a personal finance freelance writing career and has written for RothIRA.com, Discover Bank, ING Direct, and many others.


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