If you are considering taking a loan from your 401k because you need the money to pay for something, you need to know a few things about 401k loans first.
Does My 401k Allow Loans?
First, not all 401k plans allow 401k loans. The ability to take a 401k loan is a plan provision that is optional, meaning your plan may or may not allow this feature. If you are not sure whether your 401k plan allows loans or not, check with your employer or read your summary plan description, a document that you have access to as a participant in the plan.
How Many Loans May I Take?
Once you find that your plan does allow loans, you may discover that the plan allows only 1 loan at a time or that is allows many. Again, the number of outstanding loans is a provision in your plan that is set by your employer, so there are no particular rules that apply to every plan.
If your plan only allows 1 loan, know that before you request your loan. You will not be able to borrow again from your 401k plan until this loan is paid in full.
How Do I Apply For a 401k Loan?
To apply for a loan in your plan start with your 401k plan website. Many websites will allow you to model a loan and accept the loan online with no extra paperwork needed.
Other plans will need a paper application that you return to your employer. Still others may need your employer to approve the loan before it is processed.
How Much Can I Borrow?
The plan rules will declare what you can borrow, but the rules that you could expect would be that you can borrow 50% of your vested balance (that would exclude employer contributed money that is not yet yours) with a minimum and a maximum. The minimum and maximum may be customized by your plan but they are typically $500 to $1,000 for the minimum and they cannot be more than $50,000 for the maximum.
How Much Interest Will I Pay On My 401k Loan?
Your 401k plan will set up the loan interest rate, but a typical rate is something like prime + 1%. However, your plan’s rate may be different from that.
On a 401k loan you pay back the interest to yourself. In other words, you borrow money, and make payments of principal plus interest that gets deposited back into your own 401k account.
Is There a 401k Loan Fee?
Most likely, there will be an extra fee for taking a 401k loan. This is most often charged by the record keeper to offset their cost of processing the loan at the time of initiation and all future record keeping of the loan repayments. Expect to pay $50 to $200 or more for your loan. This is often deducted from your loan proceeds or taken from your 401k account so that you don’t really have to come up with the money.
How Do I Make 401k Loan Payments?
401k loan payments should be done via payroll deduction. That means that your employer should set up a per-payroll deduction for your 401k loan repayment, deduct it from your paycheck, and send it to your plan on your behalf. This means that there is nothing for you to do. If your plan works in another way it will be in your summary plan description.
How Long Do I Have to Pay Back a 401k Loan?
The maximum term of a 401k loan is set by your plan and could be as short as one year or as long as 30 years. However, a general purpose (not for a home) loan must never be longer than 5 years. Only when the loan is for the purchase of a home can the term be up to 30 years, but only if your plan allows for this home loan feature. Since that is an optional feature, your plan may only allow loans up to 5 years. Check your summary plan description to see what rules apply to your plan.
What if I Leave Employment?
If you end employment with the employer who sponsors your 401k plan, you have some options with regard to your 401k loan. First, you can pay the outstanding principal back. This means that you will face no further taxes or penalties on the distribution, but you must come up with the money.
If you cannot pay your loan back your employer may allow you to make installment payments to them that they pass on to the plan. This is not common but is permissible if your employer will do it.
If that is not an option you may decide not to pay back the loan. In this case the outstanding principal balance will be treated as income and you will pay taxes on that amount on your tax return. In addition to that, if you are less than 59.5 years old you will pay a 10% additional tax on the outstanding principal amount on your tax return.
Could I Just Take a Distribution Instead?
Maybe. If the reason you need a loan is due to a personal hardship your plan may allow a "hardship" distribution. This is another optional feature so you need to check your plan to see if it is available. Your hardship would have to be one of a few specific reasons to qualify and you will pay taxes and penalties (the penalty only if you are less than 59.5 years old) on your distribution.
Also, if you are past your plan's declared retirement age you may be able to take an ordinary distribution instead of a loan. Again, taxes will be due in the year of the distribution.
Should I Take a 401k Loan?
This is the key question for you. In general, you should not take a loan from your 401k plan. A 401k plan is there for your retirement and, even though you are paying the interest back to yourself, you are taking the money out of the market where it can grow. It is best to find another way to fund your purchase.
Even so, there may be situations where taking a loan from 401k makes sense for you. If that is the case, you now know a lot more about taking a loan from your 401k.