Employer-sponsored retirement plans tend to hold the majority of the average American household’s investment assets. While these types of accounts are designed to be used for funding your future retirement, they can provide several fringe benefits, such as the ability to borrow from your 401k.
This article will provide you with detail regarding how 401(k) loans work, along with important considerations to keep in mind before you request a loan from your plan.
Note: It is important to note that every employer-sponsored plan is unique. Each plan differs in benefits, rules, and restrictions. For questions specific to your 401(k) or employer-sponsored plan, contact your HR or Plan Administrator.
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Simply put, a loan from your 401(k) is a way of accessing funds within your employer’s retirement plan without having to take an outright distribution from the account, which would be subject to income tax on top of a potential 10% early withdrawal penalty. In other words, you are borrowing against your 401k.
When applying for the loan, you elect a repayment term, usually within the time frame of 1-5 years. Some loans may have a term of 10 years if used for a primary residence purchase. Some plans only allow for one loan to be outstanding at a time; while others allow for multiple loans to be outstanding.
You repay the loan directly from your salary, in the same way, that you contribute to the account normally. The interest rate on the loan will vary on the term, as well as the specifics of the plan.
It’s important to know that you must be actively employed with the company in order to qualify for a loan. Also, not all plans offer loans. The best place to confirm whether your plan allows for them would be your HR or Plan Administrator.
The IRS generally allows employees to borrow the lesser of $50,000 or 50% of their *vested* account balance.
For example, if your 401(k) is valued at $10,000, you can only apply for a loan of $5,000. If your account balance is $300,000, you can only borrow $50,000.
Some plans allow for the full vested balance to be loaned for amounts under $10,000. Some plans only allow for loans from specific sources (i.e: employer match, pre-tax contributions, etc.)
Remember to check with your plan for specifics related to your situation.
As mentioned earlier, 401(k) loans are not taxable, as long as they are properly structured. As long as you do not default on the loan, meaning you continue to make timely loan repayments, you will not owe any taxes on the outstanding balance.
However, if you do default, there will be tax consequences, such as income taxation on the outstanding balance of the loan on top of the 10% early withdrawal penalty.
For example, let’s assume you took out a loan for $15,000, paid down $5,000, and did not pay the remaining $10,000. The $10,000 would be included as income in the tax year that you defaulted. If applicable, you’d also have to pay a $1000 penalty if it was considered a “premature withdrawal”.
As always, everyone’s tax situation is different. Consult a tax professional with questions related to your individual circumstances.
Here is where it can get tricky. The majority of plans require employees to pay off loans around 90 days after separating from employment. Typically, you can only make loan repayments while you are still active with the employer that sponsors the retirement plan.
If you do not pay down the loan before the deadline (which should be provided by your Plan Administrator), the outstanding balance will reclassify. That means the balance will be added to your income in the year that you default and may be subject to the 10% early withdrawal penalty.
That said, there are plans that allow you to continue to make loan repayments after separating, as long as you do not miss a payment. This is something that you want to make sure you are clear on before requesting to borrow from your 401k. Most people do not have the funds required to pay down a large loan in a short period of time. The tax consequences of having a loan reclassified can be severe, so make sure you consider all of these variables beforehand.
If you are joining a new employer that has a 401(k), or you start your own, you may be interested in rolling over the balance from your previous plan to your new plan.
If you still have an outstanding loan in the previous employer’s 401(k), you are likely NOT going to be able to roll the loan over to your new plan (unless the new plan allows for loans to rollover).
Some 401(k) plans are “all or none” when it comes to distributions of funds from the account, including rollovers. If your plan requires that all of the funds be moved at once, and you have a loan outstanding when you process the rollover, the outstanding loan balance will reclassify. Again, this means the balance will be added to your income in the tax year. The 10% early withdrawal penalty may apply.
If your previous plan is not all or nothing when it comes to distributions, check to see if you can keep a portion of your balance in the account prior to rolling over the account balance to your new employer. You may be able to continue to make loan repayments, and rollover the majority of your plan balance.
Most plans have a threshold of $5,000, which is the minimum required to keep the account open without having the funds distributed to you, or moved to a rollover IRA. Make sure you ask all of these questions before you request a rollover from your previous 401(k) to your new employer-sponsored retirement plan.
When you take a loan against your 401(k), or any other employer-sponsored plan, you should be aware of the fact that you are potentially missing out on market growth (compound interest) on those borrowed dollars, on a tax-deferred basis. The main benefit of retirement accounts is the ability to have your principal grow via capital gains and portfolio income without paying tax until the funds are withdrawn.
You should also consider the impact that a 401(k) loan can have on your cash flow. Some people even have to reduce their contributions in order to be able to afford to pay the loan back via their salary deferrals.
Another thing to be aware of is the fact that you typically have to make the loan repayments via after-tax dollars. This becomes more of an issue if you believe you will be in a higher tax bracket at retirement age, because the withdrawals may be taxed at whatever that rate is.
As discussed, a loan that reclassifies can present you with an undesired tax liability. The income that is “realized” from a defaulted loan may even push you into a higher marginal tax bracket in some cases.
Careful consideration should be given to this decision, given all of the different moving pieces that are involved. Whether you are using the loan for a down payment to buy a home, to pay down higher-interest debt, or anything else, you should make sure that the numbers make sense.
What does this mean? Take a look at how your cash flow will be impacted. Will it drastically affect your ability to contribute to your 401(k) or other investment accounts? How much would you be saving on interest if you are using the funds to pay down higher-interest debt?
At the end of the day, your employer’s retirement plan should be seen as an investment vehicle for retirement goals first, and anything else second. If anything, you should view 401(k) loans as an option on the table.
Many people find the idea of borrowing from themselves attractive. 401(k) loans do not require any sort of credit check, and your credit is not affected if you default. This is because the only person that is exposed to risk is the lender, which is you in this case.
If your goal is to consolidate your debt, you may want to explore other options like personal loans, bank loans, etc. Run the numbers to see what makes the most sense, especially if the amount in question is substantial. BEFORE requesting a loan, make sure you are clear on the following:
A Final Word on Borrowing from Your 401k
401(k) loans are unique tools that may be available to investors that are in need of immediate liquidity.
Keep in mind that it is still a loan at the end of the day. The dollars that you loaned to yourself are not experiencing tax-deferred growth. That is probably the largest opportunity cost involved with 401(k) loans.
Also, make sure that you have a prudent reason for borrowing against your 401k. After all, this is still a retirement account. For example, a loan for a family vacation may not be the savviest decision.
Carefully consider all of the considerations mentioned in this article. There are plenty of cases where a 401(k) loan makes sense (i.e paying down higher-interest debt, etc.). As always, just make sure you are making an educated decision.