How Does a 401(k) Loan Work?

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Updated on Thursday, August 6, 2020

A 401(k) loan allows you to borrow from money in your retirement account. With this type of loan, you don’t make payments to a lender. Instead, your payments including interest go back into your 401(k).

This type of loan can be appealing, as there generally aren’t credit requirements and interest rates are low, typically one point below the prime rate. However, borrowing from your retirement plan can cost you more money in lost earnings compared with fees charged on traditional loan products like a personal loan.

Read ahead to see if a 401(k) loan may be worth pursuing for you.

What is a 401(k) loan?

With a 401(k) loan, you borrow money from your retirement account. Payments are typically deducted from your paycheck and you can usually select whether you want to pay back the loan on a quarterly or monthly basis.

401(k) loans are a flexible form of financing. Ways you could use this loan include:

  • Home or car down payment
  • Paying back debt
  • Home renovations
  • Childcare expenses
  • Education expenses, such as graduate school

Interest rates for these loans are typically one point above the prime rate. As of March 2020, the prime rate is 3.25%, meaning your loan would carry an interest rate of 4.25%. Unlike traditional loans, each 401(k) plan is allowed to set its own interest rate, you can check your summary plan description or ask your employee benefits administrator for details about your plan.

The borrowing limit is the lesser of $50,000 or 50% of your total balance, and the maximum repayment term is usually five years. The exception is if you use the loan toward your primary residence, in which you might have up to 25 years to pay it back. There isn’t a penalty for early repayment.

401(k) loans: Benefits and drawbacks

Pros

Cons

  • Easier to secure than other forms of financing and requires no credit check.
  • Won’t affect your credit score if you default.
  • Payments are normally deducted from paychecks, making you less likely to fall behind.
  • Is often more costly than other forms of financing in the long term because of missed retirement earnings.
  • Doesn’t build your credit history or help your score like other types of financing.
  • Not all plan administrators allow 401(k) loans.
  • If you leave your job, the money will be counted as a distribution, and you could be penalized and taxed.
  • If you leave your job, you will likely have to pay back the balance within 90 days.

How to apply for a 401(k) loan

If you’re interested in borrowing from your 401(k), you can apply through your 401(k) plan administrator’s website. Your employee benefits administrator will be able to help you find the proper webpage to apply if you’re unable to.

When applying for a 401(k) loan, you may asked for basic information such as:

  • Loan amount
  • Loan duration
  • How often you are paid
  • State of legal residence
  • If the loan will be used to purchase a primary residence

The application process for 401(k) loans doesn’t include a credit check because you’re borrowing your own money. However, if you’re married, your spouse might be required to sign off on the loan.

How much can you borrow?

Figuring out how much you can borrow from your 401(k) can be somewhat complicated.

If you haven’t had an outstanding 401(k) loan balance in the past 12 months, you are allowed to borrow the lesser of:

  • $50,000, or
  • 50% of your vested 401(k) balance, or
  • Up to the full balance if your vested amount is $10,000 or less, or
  • Up to $100,000 if you qualify for the coronavirus-related relief provisions in the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

If you have had an outstanding 401(k) balance within the past 12 months, the amount you’re allowed to borrow is reduced by the largest balance you had over that period.

Here are some examples:

  • Example #1: Chris has $12,000 vested in his 401(k) and has not had a 401(k) loan balance in the past 12 months. He is allowed to borrow $12,000.
  • Example #2: Isabelle has $30,000 vested in her 401(k) and has not had a 401(k) loan balance in the past 12 months. She is allowed to borrow $15,000.
  • Example #3: Michael has $160,000 vested in his 401(k) and has not had a 401(k) loan balance in the past 12 months. He was recently diagnosed with COVID-19. He is allowed to borrow $100,000.
  • Example #4: Eliza has $50,000 vested in her 401(k) and did have a 401(k) loan balance of $10,000 within the past 12 months. She is allowed to borrow $15,000.

What happens after 401(k) loan approval

Once you’re approved to borrow the money, you will sign an agreement to pay the loan back with interest within five years. Putting the money toward a house means the term may be extended to a maximum of 25 years. Funds are typically dispersed in your next paycheck, although this varies by company.

Payments will be automatically deducted from your paycheck until the loan is repaid. While the principal and interest you pay is credited to your 401(k) account, the interest is typically less than the investment earnings that would have resulted on your loan balance had you not taken the loan, which reduces your retirement earnings.

If you leave your job suddenly, the remaining loan balance is typically considered a distribution. That means your employer will report it to the IRS and you’ll be hit with a 10% early distribution tax on the outstanding balance.

What happens if you default on your 401(k) loan?

A 401(k) loan defaults if you aren’t able to comply with the terms of the loan and pay it back on time. That means you either didn’t make a regular payment, or you left the company and didn’t pay the loan back before your income tax return is due.

When that happens, the remaining loan balance is counted as an early distribution from your 401(k). An early distribution has the following ramifications:

  1. Unless you’re already 59½ or meet other special criteria (including coronavirus-related relief distributions), the money will be taxed and hit with a 10% penalty.
  2. The defaulted amount can’t be rolled over into an IRA, meaning you can’t avoid the taxes and penalties.

CARES Act increases borrowing limits, adds borrower protections

If you’ve been negatively affected by the COVID-19 crisis, you may be able to do an early withdrawal of 100%, or up to $100,000, of your account balance, because of the CARES Act provisions to help Americans through the crisis. You’ll need to check with your employer to see if your plan has adopted the new rules.

You can borrow more under the CARES Act provisions if:

  • You, your spouse, or your dependent were diagnosed with COVID-19 through an FDA-approved test, or
  • You’ve had financial hardship because of having been quarantined, laid off, furloughed, or had hours cut because of the pandemic, or
  • You’re unable to work because of trouble securing childcare during the pandemic or
  • You’ve had to scale back or close your business because of the pandemic.

Tax-deferred accounts affected by the CARES Act changes include traditional IRAs and employer retirement plans including 401(k), 401(b), and other defined contribution plans. It also gives you more time to pay the money back, allowing for repayments to coronavirus-related relief distributions to be deferred for up to a year.

The CARES Act can also protect you if you leave your employer before the loan is paid off. You won’t be charged the extra 10% tax you’d typically pay for early distributions. Tax payments for early 401(k) distributions can be spread out for up to three years, while taxes for 401(k) distributions are usually paid the same year.

401(k) loan vs. 401(k) withdrawal: What are the differences?

401(k) loans typically aren’t dependent on circumstances. Many retirement plans also allow for you to withdraw money from your plan early in case of hardship. These 401(k) withdrawals are supposed to be used for immediate and heavy financial needs, so consumer purchases such as for a vehicle typically don’t qualify. The IRS considers the following as immediate and heavy expenses:

  • Medical expenses for you, your spouse, or your dependent
  • Expenses related to purchasing a home
  • Rent or mortgages payments being made to avoid foreclosure or eviction
  • Tuition and education-related expenses
  • Funeral or burial expenses
  • Expenses to repair damage to your home

Hardship withdrawals are subject to income taxes and might be subject to a 10% tax for early distributions.

FAQ: 401(k) loan

Yes, you can use a 401(k) loan toward paying for a house. You’ll also have longer to repay the loan – up to 25 years compared with the typical five years.

Loans are typically repaid within five years, though many personal finance experts recommend paying it off in three years or less to minimize the loss in retirement earnings. As noted earlier, the exception is if you’re buying a house, in which you have up to 25 years to pay back.

No credit check is required for 401(k) loans, and it’s often just a matter of requesting the amount. If you’re married, your spouse might be required to sign off on the loan.

How long it takes your money to arrive varies depending on your company and plan and could take days or weeks.

There is no penalty for paying back your 401(k) loan early.

If you leave your employer, you have until you file income taxes to pay back the loan. If not, it defaults and is counted as an early distribution. You will be taxed and could be penalized 10% unless you qualify for the CARES Act or another exception.

Borrowing from a 401(k) tends to be more expensive than other types of borrowing in the long-term because of lost retirement earnings. 401(k) loans can be useful when there is an immediate financial need and the borrower has exhausted other options.

On the other hand, if you can repay the debt early, a 401(k) loan can be more appealing than financing with a higher interest rate and/or prepayment penalties.

  • Personal loans can be used for a variety of options, including consolidating debt and home expenses.
  • A balance transfer credit card may be a viable option for borrowers with high credit scores who want to refinance or consolidate credit card debt. These cards can come with an introductory 0% APR for 12 to 21 months.
  • Homeowners can utilize a home equity loan, which allows you to tap the value you have in your property. The loan is secured through your house, meaning you can access lower interest rates than on other types of loans. However, if you default on the loan, you risk losing your home.
  • Payday, title and pawnshop loans can offer short-term cash but should only be explored with extreme caution because they are often incredibly expensive to repay.

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