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 donâ€™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 arenâ€™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.
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:
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 isnâ€™t a penalty for early repayment.
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If youâ€™re interested in borrowing from your 401(k), you can apply through your 401(k) plan administratorâ€™s website. Your employee benefits administrator will be able to help you find the proper webpage to apply if youâ€™re unable to.
When applying for a 401(k) loan, you may asked for basic information such as:
The application process for 401(k) loans doesnâ€™t include a credit check because youâ€™re borrowing your own money. However, if youâ€™re married, your spouse might be required to sign off on the loan.
Figuring out how much you can borrow from your 401(k) can be somewhat complicated.
If you havenâ€™t had an outstanding 401(k) loan balance in the past 12 months, you are allowed to borrow the lesser of:
If you have had an outstanding 401(k) balance within the past 12 months, the amount youâ€™re allowed to borrow is reduced by the largest balance you had over that period.
Here are some examples:
Once youâ€™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.
A 401(k) loan defaults if you arenâ€™t able to comply with the terms of the loan and pay it back on time. That means you either didnâ€™t make a regular payment, or you left the company and didnâ€™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:
If youâ€™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. Youâ€™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:
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 wonâ€™t be charged the extra 10% tax youâ€™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) loans typically arenâ€™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 donâ€™t qualify. The IRS considers the following as immediate and heavy expenses:
Hardship withdrawals are subject to income taxes and might be subject to a 10% tax for early distributions.
Yes, you can use a 401(k) loan toward paying for a house. Youâ€™ll also have longer to repay the loan â€“ 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 youâ€™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 itâ€™s often just a matter of requesting the amount. If youâ€™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.