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401(k) plans are employer-sponsored retirement plans that allow employees to save and invest for their future in a tax-advantaged way. One important feature of 401(k) plans is the 401(k) loan, or the ability for participants to borrow money from their retirement savings.
While 401(k) loans can be a fantastic financial safety net, they aren't right for everyone, and there are some important rules to know before you use one. Let's explore how 401(k) loans work, including how much you can borrow and how long you can take to repay it.
A personal loan can be a better choice than a 401(k) loan, as it allows you to leave your retirement savings alone to grow and compound for your future. While you likely won't get as low of an interest rate with a personal loan, the difference might not be as big as you think.
Many 401(k) plans allow participants to borrow money from their accounts, which is known as a 401(k) loan. The plan participant makes regular installment payments until the loan is repaid, but instead of making loan payments to a bank, they're paying themselves back -- with interest.
The biggest drawback is that when you borrow money from your 401(k), you're missing out on the long-term compounding power of your investments.
First, not all 401(k) plans allow loans. Most do, but it is determined by the rules of your specific 401(k) plan.
401(k) plans can allow loans as much as 50% of your vested account balance, or $50,000, whichever is less. Most plans that allow loans use these limits, and if 50% of the vested balance is below $10,000, the borrowing limit will be $10,000. In other words, someone with $15,000 in a 401(k) could potentially borrow as much as $10,000 of it, even though it exceeds 50% of the vested balance.
There are also strict rules for repayment terms:
The 401(k) repayment rules say that you need to make regular and equal payments (at least quarterly) toward your loan through payroll deduction. In most cases, payments are made more frequently.
You're also allowed to pay back the loan faster than required, either by making one-time additional payments, or by paying off the entire remaining balance in one lump sum.
TIP
401(k) loans can be repaid early, without penalty. While the 401(k) loan rules state that the loan must be repaid in equal installments through payroll deduction, you also have the ability to make one-time payments in order to pay the loan back early.
You cannot change your 401(k) loan repayment or amortization schedule once you've taken a loan, with very limited exceptions (such as if you are in active military service).
If a loan payment is missed for a non-qualified reason (financial hardship is generally not a qualifying reason), the loan will be in default immediately. There is then a 90-day period where the missed payments can be made up, after which time the entire balance of the loan will become a "deemed distribution," and is treated as a 401(k) withdrawal.
To be clear, a 401(k) loan default won't result in collection activity, wage garnishments, or liens, as might be expected if you default on other types of loans. The remaining balance will simply be treated as if you had withdrawn money from your 401(k), which means that it will become taxable income and might be subject to IRS early withdrawal penalties.
Unlike 401(k) withdrawals, 401(k) loans are not taxable. You don't have to pay income tax on the money you take out.
On a similar note, 401(k) loan repayments are not considered to be contributions to your 401(k) plan. Therefore, unlike your standard 401(k) contributions through payroll deductions, your loan repayments are not tax deductible. In other words, you repay your 401(k) loan with after-tax dollars.
If you quit your job, your 401(k) loan's outstanding balance will generally be due within 90 days or will be treated as a withdrawal or distribution. If you don't have a qualifying exception, this means that the entire loan balance can be subject to a 10% early withdrawal penalty from the IRS and will be included in your taxable income for the year.
If you have an outstanding 401(k) loan, it's important to have a plan for how to deal with it if you're planning to leave your job. And it's important to mention that this same rule applies if you are terminated from employment, or if you decide to retire while you have an active 401(k) loan.
If you default on a 401(k) loan, meaning that you miss a loan payment, the loan will be in default at the end of the quarter during which a payment was missed. So, if you miss a payment during the second quarter, your loan would officially be in default at the end of June.
Once a 401(k) loan is in default, you'll have 90 days to make the missing payment(s). If you don't, the loan will be treated as a 401(k) distribution (withdrawal). This means that the entire outstanding balance will be included in your taxable income for the current year, plus you could be subject to a 10% early withdrawal penalty from the IRS unless you are older than 59 1/2 or have an exemption.
To be sure, the ability to take a loan from a 401(k) is a nice financial tool to have in case you really need the money. But they aren't right for everyone -- after all, when you borrow from your 401(k), that money isn't in your retirement account generating returns. Sure, you're paying yourself back with interest, but that isn't likely to measure up to long-term stock market returns.
With that in mind, if you need to borrow some money, there are other options that are certainly worth exploring, including:
Personal loans: A personal loan will likely have a higher interest rate than a 401(k) loan, or any of the other loan types mentioned here. But that's because it isn't backed by your retirement savings, home, or any other specific asset. However, you might be surprised at how accessible and affordable personal loans can be, especially if you have good credit.
Home equity loans/HELOCs: Borrowing against the equity you have in your home with a home equity loan or HELOC is usually a much lower-cost way to borrow money than a personal loan or credit card. Because the loan is secured by the equity in your home, it represents a much lower risk to the lender. If your home is worth considerably more than you owe, it could be worth looking into this option instead of using your 401(k).
A 401(k) loan is certainly nice to have as an option, and in many cases can make sense if you need quick access to capital at a low interest rate. Consider the drawbacks and your alternatives to borrow before you decide to dip into your 401(k).
