Loaning out money from your 401k when needed can be an inexpensive way to borrow money unless you fail to repay the loan as agreed.
As a low-interest, quick, and easy way to get your hands on money, your 401k should be your go-to option in an unexpected financial crisis. However, before you borrow money from your 401k plan, have a repayment plan. This way, you’ll avoid any serious tax consequences.
Now, you must wonder how you can borrow money from a 401k plan and what regulations apply to the loan to return it.
This guide will help you figure out the best possible method to get a 401k loan and plan to return it. So without further ado, let’s begin!
How does the 401(k) loan work?
Technically, 401(k) loans aren’t loans because they don’t involve a lender or an assessment of your credit history. You can access your retirement savings plan money tax-free for up to $50,000 or 50% of the assets, whichever is less.
After you have accessed funds from your 401(k) plan, you must repay them according to the rules put in place to restore the plan to its original state.
For a 401k loan, the interest charges on an outstanding loan balance are automatically repaid into your 401(k) account, so technically, this is a transfer from one of your pockets to another. The cost of a 401(k) loan on your retirement savings progress can be minimal, neutral, or even positive, depending on the loan’s terms.
In most cases, paying the interest over your 401k loan would be more favorable and less demanding than real interest on a bank or consumer loan.
Regulations for borrowing and repayment
Certain regulations apply to a 401k loan like any other loan. Knowing all of them is better before you claim one and weighing your options and alternatives if the loan doesn’t fit your needs.
Limits on loan amount
The IRS sets a maximum allowable amount that plans can borrow. However, plans can set limits on how much participants can borrow. If your plan permits loans, you can typically borrow up to $10,000 or 50% of your vested account balance, whichever is greater.
However, you cannot borrow more than $50,000. And while you can take out more than one 401(k) loan, your total loan balance cannot exceed these limits.
You have up to 5 years to repay a 401(k) loan, although the repayment term may be up to 25 years if you use the money to buy your principal residence. The IRS recommends that you repay your loan in “substantially equal payments,” which include principal and interest and payments made at least quarterly.
You may also be able to repay your loan through payroll deductions. The interest rate you’ll pay on loan is typically determined by the plan administrator based on the current prime rate, but the repayment schedule should be similar to what you might expect from a bank loan.
Reasons for loan
Because you are borrowing your own money, and no credit check is involved, you may be approved for a 401(k) loan as long as you meet the plan’s requirements for borrowing. In some cases, a requirement may be getting approval from your spouse (if you’re married) because your spouse may be entitled to half of your retirement assets if you divorce.
There are no strict guidelines for borrowing money in certain situations. You might use a 401(k) loan to make larger, long-term purchases, like a new home, or pay off high-interest debt or medical or educational expenses that your savings can’t cover.
Why is it better to borrow money from a 401(k) plan?
With most 401(k) plans, applying for a loan is quick and easy and doesn’t require lengthy applications or credit checks. There is no inquiry against your credit or impact on your credit score when you use a secured credit card.
Many 401(k)s allow you to request loans online with a few clicks, and you can have the funds you need in a few days with complete privacy. One recent innovation being adopted by some plans is using a debit card. This allows for multiple loans to be made in small amounts quickly.
Although regulations mandate a five-year amortization schedule, with most 401(k) loans, you can pay off your plan loan faster without paying a prepayment penalty.
Most plans allow you to conveniently make payroll payments through payroll deductions, using after-tax dollars rather than the pretax dollars funding your plan. Your loan statement shows credits to your loan account and your remaining principal balance, just like a regular bank statement.
3. Cost advantage
There is no cost, other than a modest loan origination or administration fee, to use your 401(k) money for short-term liquidity needs. You specify the investment accounts from which you want to borrow money, which is used to pay back the loan.
Therefore, any earnings that those investments would have produced for a short period are lost. And when the market slows, you sell those assets cheaper than you would at other times. And we all know that saving money is important. So the upside to this decision is that you avoid further investment losses on this money.
If you have a 401(k) plan, you may be able to borrow money from it to pay off high-interest debt or cover a big expense. But no matter how good it seems, a loan like this could cost you more than it’s worth, so it might not be the best option.
Remember that there are many different loan options available, and you should always explore all of them before deciding what kind of loan to pursue.