How does a 401(k) loan work?

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In a Nutshell

A 401(k) loan can provide a low-cost way for you to access cash when you need it. But it’s important to understand exactly how a 401(k) loan works. Unless you handle it properly, this type of loan could end up costing a lot more than you may have expected.
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If you’ve been contributing to a 401(k), you might be able to access some of the money you’ve saved early.

But a 401(k) loan could be costly. There are rules you need to follow so that you aren’t taxed on the amount you borrow. And there are possible drawbacks — like missing out on potential investment growth — to consider before deciding to take out a 401(k) loan.

Let’s look at how a 401(k) loans work, as well as the pros and cons of getting one.

How does a 401(k) loan work?

While some 401(k) plans allow you to borrow from your account, there are still some plans that don’t allow it. Look at your plan documents to see whether a loan is allowed on your 401(k) account.

If you are allowed to borrow, you’ll be required to pay your 401(k) loan back over a set period of time. A key difference with this type of loan, though, is that you’re borrowing money from yourself — so you’re paying yourself back, with interest.

Here are some other unique features of 401(k) loans.

Maximum loan amount of $50,000

A 401(k) plan will usually allow you to borrow up to 50% of your vested balance, with a maximum loan amount of $50,000.

Say you have $150,000 vested in your 401(k) account. You won’t be able to borrow the full 50%, or $75,000, of your vested balance. The most you could borrow in this scenario would be $50,000.

On the other hand, if 50% of your vested account balance amounts to less than $10,000, your plan may include an exception and allow you borrow up to $10,000.

You may be able to take more than one loan from your 401(k), but the total amount of your loan balance can’t exceed these limits.

Maximum loan term of five years

The maximum loan term is five years — with one possible exception. If you’re using a 401(k) loan to buy a home that will be your primary residence, you may be able to repay the loan over a longer period of time — up to 25 years in some plans.

Loan payments made at least quarterly

Loan payments are typically fixed and must be made at least quarterly. You might be able to make payments with after-tax deductions from your paycheck.

How do you apply for a 401(k) loan?

If your 401(k) plan offers loans, your plan administrator can provide information on the steps you’ll need to take to apply.

Keep in mind that if you’re married and planning to borrow more than $5,000, some plans will require your spouse’s written consent.

If the loan is approved, you’ll sign a loan agreement that includes details like the principal, loan term, interest rate and any fees.

401(k) loans: The pros and cons

While 401(k) loans can be a low-cost way to borrow money, there are some drawbacks to consider, too.

Pro: Low cost

Compared with other forms of borrowing, 401(k) loans are a low-cost way to borrow money. Rather than paying a lender interest, you’re paying that interest to yourself. This could be a better option than using a credit card or taking out a loan that could have a higher interest rate.

Interest rates vary, but you must be charged a rate comparable to the rate you would get if you took out a personal loan of a similar size through a traditional lender.

Con: Missed investment growth

When you borrow money from your 401(k), that money is no longer invested, which means you could potentially miss out on years of investment growth. There’s no way to know in advance how much money your investments could potentially earn, but it’s important to understand that you could lose out on some investment returns.

On top of that, if you decide to reduce or stop contributions to your 401(k) account as you repay your loan, you could miss out on any returns on those contributions. When you stop contributions, you’ll also lose out on any matching contributions from your employer.

Pro: Quick funding

Since you’re borrowing money from yourself, the process can be fast. You may be able to access your money within a week.

Pro: No credit check

Your credit scores won’t affect your ability to take out a 401(k) loan. Since you’re borrowing money from yourself, there’s no credit check.

Con: Penalties for missed payments

If you miss loan payments and your loan goes into default, it can be treated as a retirement plan distribution. That means you’ll have to pay income tax on the total amount of your loan balance. It could get even more expensive from there.

You would likely have to pay a 10% penalty tax for an early withdrawal if you’re under age 59½ and don’t qualify for an exception.

Keep in mind that if you don’t repay your loan, you’re essentially taking money from your retirement fund. Any unpaid loan amount means fewer dollars in your 401(k).

Con: Loan balance due if you leave your job

If you leave your job while you’re still paying back your loan, your 401(k) plan sponsor may require you to pay back your remaining balance in full.

If you can’t repay it, the amount of money you still owe will be considered a “deemed distribution” and could be taxed as it would be if you were to default on the loan.

To avoid paying tax at the time of distribution, you could roll over your loan balance into an eligible retirement plan by the federal income tax filing date (including extensions) for that year.

Bottom line

Depending on your financial situation, a 401(k) loan could be a good option for accessing money to pay off high-interest debt or to cover a big expense. But in other cases, this type of loan could end up costing you, so it might not be the right choice.

Before you take out a 401(k) loan, consider possible alternatives, like a home equity loan or personal loan. And if you do decide to borrow from your 401(k) account, be sure to carefully read the information and loan terms provided by your plan sponsor.

About the author: Erica Gellerman is a personal finance writer with an MBA in marketing and strategy from Duke University. She’s also the founder of The Worth Project: a weekly money newsletter you actually want to read. Her work has b… Read more.