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Taking a 401k loan – Rules and limits

For most of us, putting money away for our retirement in a 401k account is the first and only act of real savings.  These savings are intended for our retirement, so it is widely acknowledged that this money should not be touched for anything other than retirement purposes. But what if you have no where else to go? Withdraw the money from 401k? Borrow from 401k? If we withdraw the money, we not only have to pay the full income tax on that money but will also be hit with a 10% penalty for taking it before the age of 59 1/2. So what about taking a loan?

Is it possible to take a 401k loan?

Yes, according to the law. But your company is not required to include the loan option in your plan, although most companies do offer this option.

Most common reasons for 401k loans

  • Paying for college tuition
  • Medical expenses
  • Down payment for a home
  • Financial hardship – paying for the home mortgage.

How much 401k loan can I take?

Generally, if permitted by the plan, a participant may borrow up to 50% of his or her vested account balance up to a maximum of $50,000. The money you borrowed must be repaid within 5 years, unless the loan is used to buy the participant’s main home. The repayments must be made in substantially level payments, at least quarterly, over the life of the loan. The amount available for borrowing is using the vested balance.

How long do I have to repay?

  • Personal loans have to be repaid within 5 years
  • Loan for a down payment on your first home has a longer repayment period based on individual plans up to 15 yrs.
  • In most cases, the payments will be automatically deducted (after tax) from your paycheck. You usually have to decide the payment period while signing the loan papers, some plans will allow an early lump sum payoff, some won’t.

Will I have to pay tax on the loan amount?

No. As you will be paying it back, it won’t be taxed now when you take it as a loan. It will be taxed if you withdraw it or take it out during your retirement.

What about interest rates and other fees?

  • Interest rates depend on the plan. It is usually  cheaper than the rate you can get for personal loans. Check you plan for the exact interest rate.
  • There could be other fees like administrative fees/loan origination fees and an on-going maintenance fee. Count all these fees before you make a decision. A call to the 401k administrator or reading through the plan brochure should give you the information.

Can I choose which investment I can take the loan from?

Yes and No. There is no law prohibiting this, but the plan dictates how this will be handled. For example if you have 75% in stocks and 25% in a fixed income portfolio, you might want to take your loan money from the fixed income part of your portfolio, so that you won’t lose out on the stock market growth and compound interest magic. Some plans only allow distribution equally from all the fund classes (75% of your loan will come from stocks 25% from the fixed income assets). If that is the case you don’t have a choice, but make sure to ask your plan administrator about this. If you do have an option to choose, take most of the loan from fixed income assets.

Advantages of a 401k loan

  • It is easy to get. No credit check or any type of check. Just a call and some paperwork and you could have the loan.
  • The interest rate is usually less than the market rate for personal loans.
  • And you pay the interest rate to… yourself.
  • A loan is better than withdrawing the money and paying taxes & penalties.
  • 401k loans are not reported to the credit bureau. So if you are worrying about credit score, this could be an option. Note: If you are applying for a mortgage these loans are taken into consideration in your debt/income ratio by the lenders though.

Disadvantages of a 401k loan

  • The more you borrow, the less money you have to potentially grow for your retirement.
  • If you leave your company, you may have to repay the outstanding balance immediately, or within a shortened period of time. If you don’t, it will be subject to ordinary income taxes and a 10% early withdrawal penalty. This is one of the main reason why borrowing from 401k for credit card debt is not a good idea.
  • You may pay for the privilege of taking a loan – with initial and ongoing fees such as initial setup and annual loan maintenance fees (depending on your plan’s provisions).
  • If you default on your loan, the IRS considers the outstanding balance a distribution.
  • Cash Flow: Your paycheck will shrink. You will have the regular 401k contribution taken from your paycheck AND the loan repayment. So you will have less money; which might tempt you to reduce the regular 401k contribution and affect the retirement account indirectly.

What information do I need from to know before I decide to take a loan?

  • Is it possible to take a loan from my 401k?
  • How much can I take?
  • What is the interest rate?
  • What is loan period?
  • Is there a prepayment penalty?
  • How long do I have, to repay the loan if I leave or am laid off?
  • What are the loan initiation fees and what about ongoing maintenance fees?
  • Can I still contribute during the loan period?

What happens if I can’t or don’t pay the loan back?

If you can’t pay back your loan then IRS considers the balance of your loan as a withdrawal/distribution. So you have to pay all the taxes for that loan + 10% penalty for taking the 401k money before 59.5 yrs. You will receive a 1099 from the plan company of the pending loan amount to include in your tax return.

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