How much of a loan can I take from my 401k?
May 4, 2012
A 401k is a retirement plan that you can contribute to through your employer. Payments toward the 401k are removed from the employee’s paycheck before taxes are assessed; taxes are only paid once the funds have been cashed. The employer will contribute to the fund as well or match the employee’s payments. These funds are then invested into money market investments, stocks or bonds.
Upon retirement, the funds are released to the employee, where they can supplement social security or other types of retirement funds. Many people wisely choose to invest in a 401k from an early age, even their first jobs, so that they can ensure a comfortable future. Whenever you move from one employer to another, you have the opportunity to transfer the 401k or cash it out as long as you have met the employment length requirements to vest it.
Sometimes unforeseen circumstances occur that can cause financial hardship, such as a major medical condition. In these emergency situations, it may be worthwhile to attempt a loan against the 401k. Although many employers offer this option, it’s not always simple to do so and you should research your options thoroughly before taking the loan.
Can I Get a Loan from My 401k?
Employers are not required to provide loans from 401k accounts, and some companies may be unable to afford it. For the employers that do offer this, however, there are some clear guidelines in place about how the loan can be handled. State laws do not place any limitations on the purpose of a loan, but an employer can offer such restrictions. Most employers restrict loans to just a few purposes:
— Paying education expenses for yourself or your child
— Prevent eviction from your home, such as in the event of a foreclosure
— Pay for un-reimbursed medical expenses
— Buy a first time residence
Outside of these uses, many employers will not allow a loan to be taken from the 401k. Additionally, the loan must be paid back within five years, except in certain home-buying circumstances. Employees must have had no other loans taken out against the 401k for one year prior to application. Any loan that you take out from your 401k is paid back with interest to the account itself, so you lose less money in interest fees than you would with a bank loan; additionally, the loan is usually not reported back to the major credit bureaus.
Pros of Taking Out a Loan from a 401k:
— No credit checks or long applications
— Fairly low interest rates when compared to other loans
— You pay the interest back to yourself, rather than losing it to the bank
— The interest is tax sheltered
— You choose which of your investments you wish to borrow from
Cons of Taking Out a Loan from a 401k:
— Lost money on the interest you would have earned if you did
not take out the loan
— You must either pay more out of each check or reduce your contribution to cover the loan
— Defaulting on the loan can be financially disastrous
— If you are terminated, quit or change employers, you must pay back the loan within 60 days or face an automatic loan default
— The loan payment terms are not flexible
— Loan interest is not tax deductible, even if you use it to purchase a home
How Much Can I Take Out for a 401k Loan?
Depending on your balance, you can take out either 50% of your vested plan or $50,000, whichever is less. Many employers also require a minimum loan of $1,000 and restrict the number of loans that can be taken out at any given time before they’re paid off.
The loan payments are usually taken out of your paycheck alongside your other 401k payments. The interest rate assessed to these payments is usually prime plus one percent, where “prime” is the interest rate listed in the Wall Street Journal. You may need your spouse to consent to the loan.
Loan payments are not taxed and they are not subject to the 10% early withdrawal penalty as long as they are paid back appropriately. If the loan goes into default, you will be charged taxes and the 10% withdrawal penalty. Also remember that your loan payments will be taken from your payroll check at the same time as your regular 401k payments, health insurance premiums and any other expenses that are removed from your check. Be sure that you have budgeted appropriately for the loan before taking it out.
Although a loan from your 401k may be a smart idea in some situations, it should be entered carefully. Because you must pay back the loan immediately if you end your employment, it’s a bad idea to take out a loan against your 401k if you do not have job security. If the company might restructure and lay you off, if you might be fired due to performance issues or if you plan to leave the company within the next five years, you should probably not take out the loan.
Additionally, bear in mind that the purpose of a 401k is planning for your future. Although retirement can seem very far away when you are young, you don’t want to use your retirement fund as a personal line of credit to finance frivolous purchases. Otherwise you may find yourself in a position of retiring without enough money to cover your basic needs.
If you are considering taking out a loan to cover a major purchase or emergency expenses, be sure to carefully weigh your options. By choosing the best financial service for your needs, you can save money and avoid dangerous and expensive issues like high interest rates or loan defaults.
Written by Alan Dunn – one of our highly talented and underpaid writers. For more information on Alan follow him on Twitter or Google Plus