401(k) Loans: What You Need To Know

Employer-sponsored retirement plans, specifically 401(k)s, are easy and efficient tools for helping employees save for their golden years. However, if you’re an employee and you need to tap some cash now, it’s tempting to ask yourself: “How can I access this money?” The short answer: It’s fairly easy to do so, but there some important caveats to consider.

If you are younger than age 59 ½, there is a 10 percent penalty on any withdrawals you make, plus there will be taxes due. To get around these penalties, a popular option is to take a loan from your 401(k). Taking a loan from your 401(k) has several benefits and pitfalls. Let’s look at a few key considerations pertaining to this option.

The Basics: Are 401(k) loans available in my plan and how much can I withdraw?

Loan provisions for 401(k) plans are on a plan-by-plan basis. Not all plans allow participants (i.e. employees) to borrow from their 401(k)s, although the majority of plans do. Check with your employer first to make sure 401(k) loans are permitted in your plan. If so, be clear about what the loan terms are.

The amount of money you can withdraw for a 401(k) loan also varies. Standard practice is to allow employees to borrow up to 50 percent of their account balance or $50,000–whichever is less. There is also a minimum amount that can be borrowed — usually $1,000.

How does a 401(k) loan work? What is the interest rate?

Any contribution that an employee makes to his or her 401(k) plan is technically the employee’s money. Thus, when you take a loan from your 401(k) account you are essentially borrowing money from yourself. Like most other loans, borrowing from your 401(k) requires you to pay back the principal with interest. We’ve found that the interest rate on 401(k) loans is generally pegged to the prime rate (currently about 4 percent). The repayment schedule usually takes place over a 5-year period, but it can vary.

What happens if I leave my job before I pay off the loan?  What happens if the loan goes into default?

In theory, it is hard for employees to default on a 401(k) loan because most employers automatically deduct the repayments from the employee’s paycheck. It’s just like contributing to one’s 401(k). However, when an employee leaves their employer before their 401(k) loan is paid off, that’s when the risk of 401(k) loan default is more likely to occur. Plans usually allow employees to pay off their loans within 60 to 90 days of when they officially leave their employer. However, if they do not pay off their loan within that timeframe, then the loan will go into default.

If the employee cannot pay off the loan, and the loan goes into default, then the employee must pay income tax on the remaining balance (at their normal personal income rate). He or she must also pay a 10 percent penalty on the remaining balance if they are under age 59 ½. What’s more, the remaining loan balance cannot be transferred into any type of retirement plan.  Yikes!  You don’t want to default on a self-loan from your 401(k).

Conclusion

Like everything else in life, 401(k) loans have their advantages and pitfalls. If you need the money for emergencies, car payments, medical bills, etc., such loans can be a very cost-effective way to access funds. Just keep in mind the following:

  • The costs associated with the loan,
  • How long you plan on staying with your current employer, and
  • How a loan will affect your overall retirement savings.

When it comes to financial planning and retirement planning, even a small change in course (such as a 401(k) loan) can have a significant ripple effect on every other aspect of your financial life.

Please reach out anytime if you have questions about your 401(k) account or if borrowing against it makes sense for you as a way to access cash. We are happy to help!

About Patrick Melvin Jr.

Patrick D. Melvin Jr., is a Wealth Manager at Independence Advisors, LLC. Pat models client’s financial plans and works with the firm’s clients on financial planning areas such as retirement planning, investment planning and estate planning. CLICK HERE TO ASK PAT.

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