The ability to borrow from your 401k is a safety net that allows you get to money that would otherwise be tied up. Like most safety nets, ideally it’ll never get used and you’ll just get some comfort out of knowing it’s there – while successfully pulling off difficult tricks like saving for retirement and paying off debt. But you may get to a point where a 401k loan is the only option you’ve got. If you’re at that point, take some time to understand the process, the timeline, and get a feel for the potential risks before you pull the trigger.
Just Tell me What to Do
If you just want the quick version, here’s what to do: tell your employer that you want to borrow from your 401k. In the past this has been done with a paper form that you get from your company’s HR department, but it’s becoming more and more common to request loans online. You may be able to just log in to your 401k account and make the request.
How Long does it Take?
The process will take anywhere from a day (especially if you do it online) to several weeks (because several different people may need to sign off on your request). If you’re considering a loan, find out as soon as possible how long turnaround times typically are. Ultimately it depends on how quickly your request moves from your employer to the company that cuts the check, and that depends on how quickly people approve the request and send it down the line. Ask your co-workers how long it took them to borrow, and don’t be afraid to politely follow up with your employer if you’re in a hurry.
How much does it cost to borrow from your 401k plan? It depends on your plan, but you might expect to pay about $100 up front, and another $50 per year. That money is deducted from your account, so you don’t have to write a check. The real costs are the risks you take when taking out the loan: that you won’t pay it back before you quit working, and that you lose out on the opportunity to participate in market gains (if your investments would have earned money).
Can You Borrow from Your 401k?
Before you try to get a loan, make sure that you actually can borrow from your 401k under your plan’s rules. Not every plan allows loans – it’s just an option that some companies offer – and there’s no requirement that says 401k plans need to have loans. Some companies prefer not to. They might want to discourage (or prevent) employees from raiding their retirement savings, or they may have other reasons, like they don’t feel like processing loan requests and repayments. How do you find out if you can borrow from your 401k plan? Ask your employer, or read through your plan’s Summary Plan Description (SPD). If loans are not allowed, there might be other ways to get money out .
How Much Can I Borrow?
In most cases, you’re allowed to borrow up to half of your account balance, or $50,000 – whichever is less. So, if you have $40,000 in your 401k, you should be able to borrow up to $20,000. If you have $200,000 in your account, you’d only be able to borrow up to the maximum $50,000. Be sure to only consider your “vested” account balance. You can’t borrow against funds that your company contributed on your behalf if you don’t yet have full rights to that money.
It’s probably worth mentioning that it’s best to borrow as little as possible. You’ll have to repay the money, and smaller loans are easier to repay. Plus, borrowing is risky, as you’ll see below, and it’s best to minimize the amount you take out of the plan. However, you might only get one shot at borrowing, so you might not be able to borrow more if you need it in the future. That is, you might only be
allowed to have one loan outstanding at a time, and there are some other intricacies that limit how much you can borrow if you’ve borrowed from your 401k plan in the recent past.
How do you Repay?
Since you’re borrowing from your 401k plan, you’ll of course have to pay the loan back. This is typically done by taking a portion of each paycheck and applying it towards your loan. In most cases, you can borrow for a term of up to 5 years, but longer term loans may be allowed if you’ll use the money to buy your home. Again, borrowing is risky, and longer term loans are riskier than shorter term loans (it’s hard enough to predict the future 5 years out, but it’s virtually impossible to imagine what things will look like in 10 years).
When you repay money that you’ve borrowed from your 401k plan, you don’t get any tax benefits. That money is treated as normal taxable income to you, so it won’t be like any pre-tax contributions that you’ve been making to the plan. You can still contribute to the plan with pre-tax dollars (and/or make Roth 401k contributions if your plan allows) but you don’t get to double-dip and get a tax break on loan repayments. Remember: you weren’t taxed on the money you received when you took the loan.
If you leave your job (voluntarily or not) before you repay the loan, you should have an opportunity to repay any money you borrowed from the 401k. However, that’s not always easy. You probably took the loan because you needed cash, and it’s therefore unlikely that you have a lot of extra money sitting around. Try to repay if possible, otherwise you may face income taxes and tax penalties as described below. If you’ve been recruited to a new job, you might be able to get some help from your new employer.
As with any loan, you pay interest when you borrow from your 401k. Fortunately, the interest goes to your own account, so it’s a form of earnings for you. Some people assume this means that borrowing from your 401k plan is free of any drawbacks – after all, you’re paying yourself instead of some bank. While it’s true that you get some benefit from the loan, there are certainly drawbacks. First, you’re taking the risk that you won’t repay the loan. You also miss out on the opportunity to earn more than you’re paying yourself in interest. The interest rate is relatively low (it’s often based on the “prime rate,” with one percent added), but you have the potential to earn more in the markets if you’re willing and able to take risks. On the other hand, you might come out ahead if you borrow from your 401k plan just before the markets crash.
What if I Don’t Repay?
You don’t necessarily have to repay your 401k loan, but you’ll probably owe taxes and penalties if you don’t. When it’s been decided that you’re going to “default” on the loan (because you permanently stop making loan payments out of your paycheck for any reason), your loan becomes a distribution. It goes from being a temporary thing to a permanent thing – you can’t put the money back in the plan (unless you want to try and get fancy, and do a rollover within 60 days of “distribution” – talk with your tax preparer before you consider this). If the money was pre-tax money you’ll owe income tax on everything that has not been repaid, and you will likely also owe a 10% penalty on that amount. Assuming you owe $10,000 and your tax rate is 20%, you’d owe $2,000 of income tax plus an additional $1,000 of penalty tax.
In addition to taxes and returns, there are other reasons why you should avoid taking money out of a 401k plan. Especially if you’re going to pay off debt. you give up some important benefits of your 401k plan when you take money out of it.