When individuals are in a tight spot financially, they may decide to take out a loan from their 401(k) retirement plan. The interest rate for a 401(k) loan is usually a point or two higher than the prime rate, but it can vary. By law, individuals are allowed to borrow the lesserof $50,000 or 50% of the total amount of the 401(k) in a 12-month period.
Key Takeaways
- A 401(k) loan can help someone access cash in the short term to cover an unexpected expense.
- Depending on what your retirement plan allows, you can legally borrow 50% of your 401(k) savings up to a maximum of $50,000 in a year.
- In most cases, you will have to pay back the money you borrow, plus interest, within five years of taking out the loan.
- Unlike a 401(k) withdrawal, a loan doesn't require that you pay taxes or penalties, and the repayments, including interest from the loan, go back into your retirement plan.
- If you leave your current job, you may have to repay the loan in full within a short period of time.
How a 401(k) Loan Works
Your 401(k) retirement plan at work may allow you to borrow a portion of the money in your account on a tax-free basis. Usually you can take out up to $50,000 or 50% of the total, whichever is less. If your vested account balance is less than $10,000, you can still borrow up to $10,000.
You don't have to deal with a lender or go through a check of your credit history to access these funds, which usually means getting the money you need quickly and easily. And you usually have to pay interest on the loan, which is often one or two percentage points above the prime rate.
What's more, you may be able to have more than one loan at a time from your plan, provided the amount of the new and current loans aren't more than the plan's allowed maximum.
According to IRS regulations, most loans have to be paid back within five years. But you can also repay the loan faster with no prepayment penalty. Most plans allow for loan repayments to be made through payroll deductions, though with after-tax dollars, not the pretax ones used to fund your plan. (Remember, loan repayments aren't plan contributions.)
Some plans require that your spouse, if you are married, consent to a 401(k) loan.
Pros and Cons
Like any other type of debt, there are pros and cons involved in taking out a 401(k) loan. Some of the advantages include convenience and the receipt of the interest paid into your account. If you take out a 401(k) loan and you pay 7% interest on it, for example, that 7% is going back to your 401(k) because that is where the money came from. In fact, if you pay back a short-term loan on or even ahead of schedule, it may have a negligible impact on your retirement savings.
One major disadvantage of a 401(k) loan is the loss of tax-sheltered status in the event of a job loss. If you take out a loan on a 401(k) and you lose your job or change jobs before the loan is fully repaid, there is a time period in which the full amount of the loan has to be repaid. If the loan is not fully repaid at the end of the grace period, not only does the amount become taxable, an additional 10% penalty is charged by the Internal Revenue Service (IRS) if you are under the age of 59½.
Advisor Insight
Timothy Baker, CFP®, MBA
WealthShape LLC, Windsor, Conn.
This may sound like a good option for those in need of funds but there are a few things to consider.
The loan will have interest attached to it. While that interest payment does go back into your account, consider the opportunity cost of what you could have earned if the loan amount was invested.
Depending on the stipulations of your 401(k) plan, you may or may not be able to make additional contributions while you’re in the process of paying back your loan.
Other options to consider are hardship withdrawals, though they have significant conditions according to the IRS code, or a home equity loan.
Another possibility is taking a series of equal periodic payments, which can help to avoid the 10% early withdrawal penalty. Withdrawals must last a minimum of five years or until age 59½.
Can I Access a 401(k) Loan With a Debit Card?
Previous terms and conditions allowed account holders to access certain 401(k) loans using their credit or debit cards. But plan administrators are no longer permitted to allow this option under Section 108 of the SECURE Act, also known as the Setting Every Community Up for Retirement Enhancement Act.
The act was signed into law on Dec. 20, 2019, as a way to help boost the landscape for retirement benefits in the United States and strictly prohibits the use of credit cards and other similar vehicles to access loans made through 401(k)s.
What's the Difference Between a 401(k) Loan and a Hardship Withdrawal?
A loan from your 401(k) is money that you borrow from your retirement savings and then pay back over time, along with interest. A retirement plan may also allow participants to receive a hardship distribution (or withdrawal) if they have an "immediate and heavy need," according to the IRS. Examples include medical expenses for you, your spouse, or your dependents; costs directly related to the purchase of your principal residence (excluding mortgage payments) or expenses to repair damages; and certain educational expenses, among other needs. The amount of the distribution is limited to what's required to cover the financial need.
Other key differences between a loan and a hardship distribution: the latter is subject to income taxes and also may be subject to a 10% tax on early distributions, and it cannot be repaid to the plan.
How Much Interest Do You Pay on a 401(k) Loan?
Typically, retirement plans charge the current prime rate plus 1% or 2% in interest on 401(k) loans. That interest, along with your repayments, is deposited into your account. Keep in mind that although it's like paying yourself back, you're doing it with after-tax funds.
The Bottom Line
A 401(k) loan can be a smart way to access needed funds, provided you understand the rules involved. Before you take one out of your retirement account, be sure you understand your plan's requirements and repayment terms. And if you go ahead with it, try to repay the loan quickly so that it has as little effect on your retirement savings as possible.
