401(k) Loans: How Do They Work?

By Jana Samek, Relationship Manager – Qualified Plans

Having access to a 401(k) plan through your workplace is a wonderful thing. Over half (56%) of US employers offer this employee benefit. If you have a 401(k) plan and face a financial emergency, there may be an option you are unaware of. You may be able to take a loan from your vested balance, depending on the provisions of your plan.

Keep in mind, the purpose of a 401(k) is to save for retirement. If you take money out of it now, you’ll risk not having enough money saved in retirement, especially if you don’t have any other savings put towards your retirement years. You may also incur stiff tax consequences and penalties for withdrawing before age 59½. Before taking a loan, the question you should ask yourself is will taking money from my 401(k) today jeopardize my financial security in the future?

A 401(k) loan lets you borrow money from your retirement savings account and pay it back over a period of time. Both the loan payments and interest go back into your account.

There is a legal limit on how much you can borrow. Generally, the maximum you can borrow within a 12-month period is $50,000, or up to one-half of your vested plan balance, whichever is less. In most cases, you must pay that borrowed money plus interest within five years of taking the loan. If the money is not paid back within the terms of the loan, the unpaid money could be defaulted, and taxes and penalties will apply.

Taking out a 401(k) loan isn’t necessarily a bad thing. In some cases, it may be the best option available for handling a cash need or emergency. It’s important to understand the pros and cons of borrowing from your 401(k) prior to taking the loan out. You will also need to determine if you can comfortably pay back the loan. 

Pros:

• No credit check is required for taking out a loan, and there’s generally little paperwork that needs to be completed. The fees may also be limited.
• Unlike 401(k) withdrawals, you do not need to pay taxes and penalties on the amount you borrow as long as the loan is repaid on time.
• Interest rates are generally low (usually 1 to 2 percent above the prime rate), plus you’re paying the interest to yourself.
• Loan payment plus interest is automatically deducted from your paycheck.

Cons:

• You may lose out on any tax-deferred (or in the case of Roth accounts, potentially tax-free) investment earnings that may have accrued on the borrowed funds if they had stayed in the plan.
• Loan payments are made with after-tax dollars. These dollars may be taxed again when you eventually withdraw the money in retirement – that’s double taxation!
• If you don’t pay back a 401(k) loan when required, it will generally be treated as a taxable distribution and additional penalties could be assessed.
• If you leave your employment (whether voluntarily or not) and have an outstanding loan balance, you may need to repay that balance in full or risk having it be considered a distribution. In this case, it becomes taxable income to you. If you are under age 59½ years old, a 10% early withdrawal penalty tax will also apply. (See your plan administrator for more specific plan provisions.)
• Loan interest is generally not deductible (unless the loan is secured by your principal residence).
• While they may be lower than a traditional loan, 401(k) loans do have fees to cover the processing and administrative costs.

If you decide to take a 401(k) loan, here are some helpful tips:

• Pay it off on time and in full.
• Avoid borrowing more than you need or too many times.
• Continue saving for retirement to keep your retirement savings on track so you don’t set yourself back. This is especially important if your plan offers a match to your savings.
• Remember that if you don’t repay the loan on time, it becomes a distribution that has tax repercussions.

It is also important to note that 401(k) accounts are governed by the Employee Retirement Income Security Act of 1974 (ERISA) and assets within a plan are protected from creditors. This means a creditor cannot seize or garnish assets held in your 401(k) account. If you take a loan out against your 401(k), the assets you have removed from the plan are not protected by ERISA until they are back in the plan. Federal tax liens and court-ordered family obligations such as child support, alimony, or divorce proceedings do not fall under this protection.

Remember, not all 401(k) plans allow for loans, and every plan has different rules. Check with your plan administrator or read your Summary Plan Description for more information.