Everything You Need To Know About 401k Loans

401k loans allow you to borrow from the balance that you have built up in your 401k account. 401k plans are not required to offer loans as a part of the plan. If you are looking at taking a 401k loan, double check that your specific plan allows you to do so.

You are allowed to borrow up to 50% of the vested balance up to a maximum amount of $50,000. Your vested balance simply refers to the amount of money in the account that is fully owned by you. Your contributions are always owned by you, but an employer match may have a vesting schedule in which the money they contribute will not be yours immediately.

401k loans are unique in that the loan amount and interest is paid back to you and not a lender. For example, say you had a $50,000 401k balance and took out a loan for $10,000. As you pay back this $10,000 loan the principal payment and interest goes back into your account and not to a lender.

With that being said, the repayment terms of 401k loans can be restrictive. In general, you must repay your loan within 5 years in level payments such as weekly, biweekly, monthly, or quarterly. Additionally, some plans will require you to repay your loan balance in full if you leave your job or lose your job.

Failure to repay a 401k loan can result in a taxable event which we will look at later on. 401k loans may be a viable last effort solution if you have exhausted all other possible options. However, it is typically not the best idea. Let's dive into this more below.

The regulations around 401k loans require that 401k loans have "reasonable interest rates." There is not a specific interest rate that plans must abide by, but due to the regulations the interest rate is often lower than alternative borrowing options such as credit cards or personal loans.

Now, that is not to say that you should view 401k loans as a "great idea." However, if borrowing money is truly your only option to meet your needs, 401k loans may be a solution. For example, say that you recently lost your job and did not have an emergency fund or any other savings you could use.  

This is a stressful situation that many people find themselves in. If you were or are one of them, you would likely be in the process of trying to figure out how to pay for your necessities. Many people would pay for their bills with a credit card or personal loan that can have interest rates upwards of 20%.

In this scenario, the interest rate on a 401k loan may be half that. Again, the point here is not that 401k loans are awesome, but relative to the alternative borrowing options, they may be better.

As previously mentioned both the principal and interest payment of a 401k loan go back into your 401k when you repay it as opposed to going to a lender. For example, say that you found yourself in a financial pinch and borrowed $10,000 from your 401k loan at a 5% interest rate.

As you pay off this loan, the principal of the loan and 5% interest added onto the principal go back into your account. You are not sending this money to a bank or credit union. Again, this does not mean that 401k loans are inherently awesome.

The downside here is that when you pull money out of your plan you lose the opportunity for those dollars to keep growing in your account which we will look at in a bit. However, you are repaying yourself the money and interest as you are both the lender and the borrower when you take a 401k loan.

If you have a traditional 401k, withdrawals will be taxed as income. Additionally, if you take a withdrawal before you are 59 and a half years old you may be subject to a 10% penalty on top of the applicable income taxes depending on what the withdrawal will be used for.

However, you will not be subject to taxes on penalties when you take a 401k loan as long as you repay the loan and follow the specific rules of your 401k plan. The money still leaves your 401k when you take out a loan, but it is a potential solution if you do not want to pay any applicable income taxes and/or penalties.

The fourth and final potential advantage of a 401k loan is that your credit score will not be impacted. Since you are borrowing the money from your own plan, a credit check is not a necessity with a 401k loan. Many other loans do require a hard credit check.

The biggest potential danger of taking a 401k loan is that you lose the opportunity for your dollars to grow from the investments (typically mutual funds) that you hold in your account. For example, say that you took a $10,000 loan from your 401k.

Let's assume that you plan to pay back this loan within the required time frame of 5 years. Assume that the investments that you hold in your account could earn an average of 10% over those same 5 years. Using these assumptions that same $10,000 loan would be worth $16,105 in 5 years.

When you took a loan out of your 401k you lost the opportunity for this money to grow. However, the problem is larger than this. You would need to put extra money into your 401k on top of repaying the loan in order to get back on track with your retirement.

If you failed to do so, the potential losses would get larger over time. For example, say that you never put any additional money back into your retirement plan over the next 20 years. That $10,000 loan would have cost you $67,275 assuming an average return of 10% from your investments.

Failure to repay your loan under the applicable rules of 401(k)s and your plan specific rules can send your loan into default which can turn your loan into a taxable event. As previously mentioned, 401k withdrawals are taxed as ordinary income.

When your loan defaults, the IRS no longer views it as a loan and instead views it as a taxable withdrawal. This withdrawal will be added onto your income. For example, if you make $80,000 and had a defaulted $10,000 401k loan your new taxable income for the year would be $90,000.

Additionally, you may be subject to an additional 10% penalty on top of any applicable income taxes if your loan defaults. This is a big risk of 401k loans that many investors fail to consider. Make sure you are able to pay back your loan in order to avoid a taxable event.

401k loans have strict terms that are not always going to be favorable as a borrower. As previously mentioned , you can only borrow 50% of your vested balance up to a maximum of $50,000. If you had an account balance of $10,000 the most you could borrow would be $5,000 which may not be enough depending upon your individual circumstances.

Additionally, you must repay the loan within 5 years. Beyond these broad rules, your specific 401k plan may have additional rules that you must follow. For example, some plans require you to pay off your loan in full when you leave your job.

If you took out a loan and left your job two years later, you can be put in a tough spot financially if your plan requires you to pay off the loan in full. Failure to do so may result in a taxable event. It is important to be aware of the terms of your specific 401k loan before you borrow money from your plan.

401k plans are not required to offer loans as a service of the plan. Your specific plan has to decide to offer loans as part of the plan. If your plan does not offer loans as a service, you are out of luck. However, there may be some alternative options that you can consider.

When looking for ways to borrow money when needed, it is important to consider all options. There are several alternatives that may be more viable than 401k loans. Some of these may be readily available to you, but if they are not it is still worthwhile to look into them for any potential future needs.

Many investors who take out 401k loans are doing so out of a sense of financial desperation. They are not using the money to go on vacation, but are often using the money to pay bills when they lose their job, get sick and need medical attention, and more.

In an ideal world, you would have an emergency fund set up to pay for these unexpected expenses. An emergency fund is simply a liquid cash reserve that you can use to cover unexpected expenses. Having an emergency fund will make it easier to resist a 401k loan and allow your retirement dollars to keep growing.

If you do not have an emergency fund set up already, a 401k loan can still be a last resort option. However, as you think through your entire financial picture, it is important to build an emergency fund so that you can be better prepared for the future.  

Many of us have lots of stuff that we no longer need or use. If you are desperate for money and would like to preserve your retirement savings and avoid the strict terms of 401k loans, you can have a "garage sale." This does not have to be a literal garage sale, but the point here is that you can try to sell some of the things you own to come up with cash.

This is not going to be a "fun time" to have to sell some of your belongings, but it may be a better solution than taking out a 401k loan. Try to view your retirement savings as retirement savings. This may motivate you to find other ways of coming up with money instead of pulling the money out of your 401k and taking from your future self.

HELOCs, or home equity lines of credit, allow you to borrow against the equity that you have in your home. HELOCs are secured by your home and work using a revolving line of credit. Essentially, you can borrow what you need within the limits of the HELOC and are only charged interest on the amount you borrow.

HELOCs may be better than 401k loans due to the fact that HELOCs are more flexible and that the interest rates are often favorable. It is important to work with a competent lender who can explain what a HELOC would look like for you such as the amount you could borrow, the interest rate, and more.

Life insurance is typically only thought of as income replacement for loved ones if you were to pass away unexpectedly. While this is true, there are other types of life insurance policies that allow you to borrow against the policy. These loans may be a better solution than a 401k loan depending upon your individual circumstances.

Term life insurance offers a set amount of coverage for a set time. If you die during this time, the policy pays out and if you don't the coverage ends. Permanent life insurance on the other hand works a little differently. One of the most popular types of permanent life insurance is called whole life insurance.

Whole life insurance is a type of life insurance policy that covers you for your entire life if you pay the premiums and also allows you to borrow against the policy. When you pay a whole life insurance policy, your money goes into three buckets.

First, your money goes towards the cost of your insurance policy. Second, your money goes towards the administrative costs of your insurer. Finally, the money goes into what is called cash value. Cash value is a portion of a whole life insurance policy in which you earn a guaranteed rate of return from the insurer.

As this cash value grows over time, you can borrow against the policy. For example, say that you had a whole life insurance policy and had built up $50,000 worth of cash value. You could call up your insurer and ask to borrow against this amount.

Note the word "against". When you take out a whole life insurance loan, your cash value does not leave the account. Instead, the cash value is used as collateral for the loan. This means that your cash value will continue to grow even when you take out a loan.

Life insurance loans may be a more viable solution than 401k loans as your money stays in an account that can continue to grow and offer very flexible repayment options. Permanent life insurance policies are complex financial products so make sure to work with a competent insurance agent before purchasing one.

The bottom line is that 401k loans allow you to borrow money from your retirement account if your plan allows it. 401k loans may be a viable solution for you depending upon your individual circumstances, but it is vital to carefully weigh the pros and cons before pulling money from an account that is designed for your future.

401k loans may offer reasonable interest rates, will help you avoid taxes and penalties, and do not impact your credit. However, the opportunity cost of pulling money out of your account may be large, any loans may become taxable if they go into default and the rules that you must follow in regards to 401k loans are often strict.

It is important to consider alternative options before immediately using a 401k loan. If you do not have any alternative options, a 401k loan may be a viable solution as a last resort but in general you should not take out 401k loans on a consistent basis. It will typically not benefit your overall financial picture over the long term.