401k Loans - An Overview
Allowing loans within a 401(k) plan is allowed by law, but your employer is not required to offer them. Even so, loans are a feature of most 401(k) plans. Many small business just can’t afford the high cost of adding this feature to their plan. Check with your Human Resources department if you’re not sure if your plan allows loans. If offered, your employer must adhere to some very strict and detailed guidelines on making and administering them.
Most of the time loans are only allowed for the following reasons: (1) to pay education expenses for yourself, spouse, or child; (2) to prevent eviction from your home; (3) to pay un-reimbursed medical expenses; or (4) to buy a first-time residence. You must pay the loan back over five years, although this can be extended for the first-time home purchase.
Usually you are allowed to borrow up to 50% of your vested account balance to a maximum of $50,000 (set by law). Because of the cost, many plans will also set a minimum amount and restrict the number of loans you can have outstanding at any one time.
If loans are available in your plan, they are pretty easy to get. No credit check is required. Contact your Human Resources department on how to apply. Loan payments will generally be deducted from your payroll checks and, if married, you may need your spouse to consent to the loan.
Funds obtains from a loan are not subject to income tax or the 10% early withdrawal penalty. If you should terminate your employment, often any unpaid loan will be distributed to you. You will be subject to income tax and, if your are not at least 59½ years of age, the 10% withdrawal penalty. A loan can’t be rollover into an IRA.
There are generally four reasons given to avoid 401(k) loans if possible:
-
Lower investment return. According to the General Accounting Office, the interest rate you pay yourself on your plan loan is often less than the rate your plan funds would have otherwise earned, and you lose the benefits of compound interest.
-
Smaller contributions. Because you now have a loan payment, you may be tempted to reduce the amount you are contributing to the plan and thus reduce your long-term balance.
-
If you quit working or change jobs, you must pay back the loan right away. It's not uncommon for plans to require full repayment of a loan within 60 days of termination of employment. If you don't repay, the loan is considered defaulted, and you are taxed on the outstanding balance, including excise taxes in many cases.
-
Repayment of principal and interest is made with after-tax dollars. By contrast, a home equity loan from a bank is often structured so that the interest you pay is tax-deductible. On a larger loan, this could add up to significant savings.
Information provided in partnership with 401khelpcenter.com, LLC. 401khelpcenter.com, LLC is not the author of the material unless specifically noted. We do not endorse and disclaims any and all responsibility or liability for the accuracy, content, completeness, legality, or reliability of the material. THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND IS NOT INTENDED AS LEGAL, TAX OR INVESTMENT ADVICE.