401(k) Loan Rules: Borrowing From Your 401(k)

Although it might go against general financial wisdom to borrow from your 401(k), it might be the best option you have.

401(k) loan rules are complicated, but no need to worry. In this article, we are going to cut up 401(k)s into small pieces. That way you can better understand what’s right for your situation.

We will take you through the following:

  • Basic understanding for 401(k)s
  • How to borrow for your 401(k)
  • Borrowing limits
  • Repaying your 401(k)
  • Advantages and disadvantages of borrowing
  • Should you borrow from your 401(k)

Whether you’re interested in 401(k)s or debating your next move, you will be much more knowledgeable in this subject after this article.

Quick Facts: 

  • You can borrow the lower of the two options: $50,000 or 50% of your vested account.
  • Paying back your 401(k) will be automatically taken from your paycheck (after taxes).
  • Some 401(k) plans do not allow you to support your 401(k) retirement fund until you pay back the loan (check your plan).
  • Not all companies allow you to borrow from your 401(k) (check your plan).
  • Failure to pay back the loan will result in financial penalties.

If you don’t have much saved for your retirement years in your 401(k), it’s not the best idea to borrow. Nonetheless, borrowing from your 401(k) can offer conditions that you wouldn’t be able to find elsewhere.

Before you decide anything, make sure you fully understand the process. Reading this is a great start!

What Is a 401(k)?

A 401(k) is a tax-advantaged retirement plan. 401(k)s are retirement saving plans provided to employees by employers.

Employees consistently make contributions to their 401(k)s through automatic payroll and employers match a portion of those funds.

The 401(k) was designed to help Americans live their golden years more comfortably with personal funds. The earnings in your 401(k) aren’t taxed until you withdraw the amount.

There are many retirement savings accounts to choose from such as Roth IRAs, 401(K), 403(b)s, and more.

How Do You Borrow From You 401(k)?

Not everyone can borrow from their 401(k). You must check your plan documents to ensure that you can borrow for the specific reason you had in mind. 

If you’re serious about borrowing from your 401(k), speak with your 401(k) provider and understand your agreement. 

Let’s check out the process 

Credit Check

There is no credit check when you borrow from your 401(k).

Why? 

This is because the money you’re borrowing is already yours! It is designated to be for your retirement (and not from an external loan source). Therefore there is no need to check your credit.

Application Process

401(k)s weren’t created for “loans”, so there is no credit check and the application process is much smoother than getting a loan.

Generally, there is less paperwork, less waiting, and lower application fees associated with 401(k) loans (if there are any fees involved in the transaction it will depend on your 401(k) provider).

What Are The 401(k) Limits?

401(k)s came about in the late 1970s and was put into the section of the IRS code. Therefore, your 401(k) is governed by legal loan limits. 

The most you can borrow from your 401(k) is $50,000 or 50% of your vested account (whichever is less). 

Your vested account refers to the amount of money you can take with you when you leave your employer. Don’t forget, your employer also contributes funds to your 401(k).

How Do You Repay Your 401(k)?

Your 401(k) wasn’t designed to be a personal loan and therefore shouldn’t be looked at like one. Borrowing from your 401(k) and getting a loan are two totally different things. 

Paying back your 401(k) is also different from paying back a loan. You basically pay back your 401(k) through your payroll. There are automatic deductions from your paycheck that go back to your 401(k).

Most payment plans are finalized before you borrow the money. It is common to pay back your 401(k) monthly or quarterly. If you are repaying your 401(k) you may not be able to financially contribute to your 401(k) account.

Advantages of Borrowing From Your 401(k)

As mentioned before, the process of borrowing from your 401(k) is much less of a hassle compared to getting a loan. Taking out your 401(k) is simply withdrawing your own funds.

There is likely less paperwork involved and processing times are faster than the traditional bank loan.

Interest Rates

Interest usually has a negative relationship when talking about a loan. Well, it’s not that way when your borrowing from your 401(k).

You’ll have to pay interest when you repay your 401(k), but you’ll be paying yourself!

The interest rate is stated in the rules of your 401(k). It is usually broken down by a prime + a low percentage cost.

Cost Advantages 

There is usually no cost or fee to borrow from your 401(k) (if you repay according to plan). When you decide the amount of money needed, specific investments in your 401(k) are cashed out and you can use the money.

Tax

Borrowing from your 401(k) has zero tax penalties even if you wish to withdraw your 401(k) early.

Just be sure to honor the payment plan. That way you won’t experience unnecessary financial penalties. 

Disadvantages of Borrowing From Your 401(k)

While borrowing from your 401(k) is excellent for emergency situations, it can create bad financial habits. 

Regardless of the convenience and low-cost factors, borrowing from your 401(k) should be used as a last resort. Don’t forget, your 401(k) is your retirement fund, and it’s not worth gambling.

Let’s look over some of the disadvantages of borrowing from your 401(k).

Loss of Potential Gains

When you borrow money from your 401(k) you are essentially pulling out money from the stock market.

If the stock market does really well after you borrowed money, you will be giving up on potential gains. 

Fewer Retirement Funds

At the end of the day, you will have less money in your retirement fund. If you take money from your 401(k) you will have to repay what you took.

Paying back what you took takes time and will leave you with less money in you 401(k) when you retire.  

Late Payment is Costly

Just because we plan out life doesn’t mean life listens. If you do not repay your 401(k) in time you may be subjected to financial penalties.

If you decide to leave your employer while you have a 401(k) loan, the loan must be paid back. 

If you can’t pay it back, it will be considered defaulted and you will be taxed on the outstanding balance. You may even be penalized with an early withdrawal fee if you are under the age of 59 ½.  

Should I Borrow From My 401(k)?

When it comes to borrowing from your 401(k), there are obviously many things to consider.

Even though you probably have hundreds of thousands of dollars in your 401(k), know that you could be putting your future retirement at risk.

Be sure to carefully weigh the advantages and disadvantages of borrowing from your 401(k). This shouldn’t be your first outlet if you are short on cash.

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