Everything You Need to Know About 401(k) Loans

More and more people are looking for a way of securing 401(k) loans in order to have access to cash. But what exactly is a 401(k) loan and how do you go about getting one? In case you’re like most Americans, your 401(k) is one of your largest sources of savings. And if you’re facing a financial emergency, you may be considering taking out a loan from your 401(k).  

But before you do, it’s important to also understand the risks and benefits associated with taking out this loan. So, let’s first cover the basics.  

A 401(k) loan is a type that’s taken out against the balance of your 401(k)-retirement account. The money you borrow can be used for any purpose, but if you don’t repay the loan within a certain time frame, typically five years, it will be considered a withdrawal from your account and subject to income taxes and possible early withdrawal penalties.  

There are two main benefits of taking out a 401(k) loan: convenience and cost. They are looked at as an easy way to get access to cash when you need it. Unlike other types of loans, there’s no lengthy application process or credit check required. And because the money comes from your own retirement savings, you don’t have to worry about qualifying for a loan or making monthly payments to a lender. Another reason so many people decide to take out this type of financing is that it can be relatively inexpensive.   

In this article, we’ll further explore the ins and outs of 401(k) loans from how they work to who is eligible and whether or not it’s a good idea in the first place. So, if you’re considering taking out a loan on your 401(k), read on to learn more and make a well-informed decision in the end.  

A 401(k) Loan: What Exactly Is It?

A 401(k) loan is a loan that is taken out against the balance of your 401(k) account. The loan is typically used for short-term financial needs, such as paying off debt or covering unexpected expenses. The interest on it is paid back into your account, and the repayment schedule is set up so that you have some plan for the payments.   

If you are in a need of cash and considering taking out a 401(k) loan, there are a few things to keep in mind. First, you will need to check with your plan administrator to see if loans are allowed under your particular plan. Second, loans from 401(k) accounts are not available to everyone and generally, you must have a vested balance in your account of at least $10,000 in order to be eligible. These are just some of the 401(k) loan rules you need to be aware of.  

Finally, it’s important not to overlook the fact that taking out a loan from your 401(k) will reduce the amount of money available to you when you retire. If possible, it’s always best to avoid taking out a loan from your retirement savings. However, if you do need to take out a loan but want to stay away from personal loans, 401(k) can be a good idea. Just make sure to repay it as quickly as possible so that you can minimize the impact on your future retirement security.  

How Do 401(k) Loans Work?

Now that you know you can borrow money from a 401k, let’s take a look at how this process works.  

To get a 401(k) loan, you must first contact the plan administrator. They will provide you with information about how to apply for a loan and what the terms of the loan are. The money you borrow is not taxed, and you don’t have to pay any fees or penalties. You will, however, have to pay interest on the loan.   

The interest rate on a 401(k) loan is usually lower than the interest rate on a personal loan or credit card. This makes them a good option if you need to borrow money and want to avoid paying high-interest rates.  

But, how much can you borrow from 401k? Well, this is usually up to 50% of your vested account balance, up to $50,000. The term of the loan is typically 5 years, but some plans allow you to choose a shorter or longer repayment period.   

And another important thing to note here is that if you leave your job before the loan is repaid, you will generally have to repay the entire amount within 60 days or it will be considered a withdrawal from your account and subject to taxes and penalties.   

Pros and Cons of 401(k) Loans

The 401(k) loans can be a great way to access the money you’ve saved for retirement, but there are some things to consider before taking out this loan. Here we will list the pros and cons of 401(k) loans so you can make a good decision down the road.  

The main advantage when you borrow from 401k is that there are no high fees and lenders you need to deal with. The interest rate will be much lower than you could ever score on a credit card or personal loan.  

As for the drawbacks, certainly, the biggest one is the fact that if you leave your job, you will have to repay the loan within 60 days.   

Pros  

• You can borrow up to 50% of your vested account balance, with a maximum loan amount of $50,000.  
• The interest rate on a 401(k) loan is typically lower than the interest rate on any other loan.  
• The 401(k)-loan payback plan usually just includes a deduction from your paycheck, so you don’t have to worry about making payments yourself.  
• You don’t have to pay taxes on the money you borrow from your 401(k).  
• They can be a great way to fund a major purchase. Additionally, you can use a 401(k) loan to refinance other high-interest debt.  
• Having a loan can help improve your credit score in general, just by demonstrating your ability to make regular payments on time.  

Cons    

There are also some 401(k) loan cons which include:  

• You will still have to pay interest on the loan, which can add up over time.  
• If you leave your job before the loan is paid off, you may be required to repay the entire loan within a short period of time.  
• The funds from your 401(k) account will be unavailable to you during the repayment period.  
• If you default on the loan, there could be legal actions taken against you.   
• If you can’t repay it, the amount will be considered taxable income.   
• There is also sometimes an early withdrawal penalty to be paid.  

When is a 401(k) Loan Useful?

There are a few instances when taking out a loan from your 401(k) can make sense. If you have a genuine financial emergency and don’t have other sources of funds available, borrowing from your retirement savings can help you get through a tough time without resorting to high-interest credit cards or loans.  

Another time when a 401(k) loan can be helpful is if you’re trying to avoid paying taxes on a large sum of money. If you have a good 401(k) balance and are in a high tax bracket, taking out a loan and investing the proceeds in a Roth IRA can help you save on taxes in the long run.  

Of course, there are also times when taking out a 401(k) loan is not advisable. So, if you’re already behind on your retirement savings, borrowing from your 401(k) will only make it harder for you to catch up. And if you leave your job before repaying the loan, you’ll likely have to pay taxes on the outstanding balance plus a 10% early withdrawal penalty.  

Must You Take Out 401(k) Loans?

So, while taking out a 401(k) loan may seem like an attractive option at first glance, there are definitely some risks involved that you should think about.  

As we already discussed there are other loan options available to you that may be a much better fit. Additionally, if you are not planning on staying much longer in your current job, these loans can be a rather bad option as you will need to repay them within two months of quitting.  

There is no one loan type that fits everyone and that’s why it is important to be as educated as possible on different loan options. And lastly, if you’re planning on tapping into a 401(k) from a company you no longer work for, you’re out of luck. Unless you’ve rolled that money into your current 401(k) plan, you won’t be able to take a loan on it.  

401(k) Loan Alternatives

There are some loan alternatives that you could consider if you’re looking to finance a large purchase or consolidate debt.   

Personal loans – They can be obtained from a bank, credit union, or online lender. Personal loans typically have fixed rates and terms and can be used for a variety of purposes.   

Home equity loan – This one uses the equity in your home as collateral. They usually have lower interest rates than other types of loans, but they do come with the risk of losing your home if you default on the loan.   

Credit cards – Finally, you could consider a balance transfer credit card. These cards offer low introductory rates on balances transferred from other cards and can be a good option if you’re carrying high-interest debt.  

Before taking out a 401(k) loan, consider whether other options, such as the ones we mentioned are more suitable. Nonetheless, you could also try to borrow money from family or friends. 

Conclusion

In today’s world, borrowers have access to a wide variety of loans, so picking the best one can be challenging. Taking any loan can be risky if you are not familiar with the terms and conditions before signing up so do your research beforehand.  

In this article, we thoroughly covered how to take out a loan against your 401k, but the ultimate decision of whether you should do it is up to you.  

Whatever option you choose, don’t forget to shop around and compare interest rates, fees, and repayment terms. And if this all gets too confusing for you, we suggest you hire an experienced financial advisor to help you figure out if you can get a 401k loan and how to do so.