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With the rising cost of living, there is a pressure to save more for retirement. This is reflected in the average value of retirement accounts by family. As you can see in the following chart using FED Survey of Consumer Finances data:
What are 401(k) Loans?
In today’s world, economic hardship is on the rise. People have to find avenues to get the money they need fast to cover debt and other expenses. Whether it’s IRS tax debt or paying off a car loan, people discover that they have big bills that they can’t afford to pay because of not having an emergency fund.
In a situation like this, what would you do? Most people were opt-in to take out a 401k loan. ¾ company 401k plans are set aside for those who need a 401k loan. Moreover, 30% of individuals take advantage of the 401k loan to cover debt and other expenses.
Getting a 401k loan is a good option for those who owe a serious amount of debt to the IRS or going through a foreclosure. Don’t be ignorant of the risks that come with taking out a 401k loan.
How 401(k) Loans Work
Before we dive into the advantages and disadvantages of 401k loans, let's observe how they work. Even though the rules and regulations of 401k plans may vary, they all share similar fundamentals.
- Minimum withdrawals: 401k plans have a minimum amount a borrower can take out. It ranges from $500-$1000. In order to prevent people from short-circuiting their investment gains, lenders attempt to discourage borrowers from taking out small loans on a frequent basis.
- Maximum loan amounts: Lenders allow people to borrow up to 50% of what is currently in their 401k. They don’t allow them to take more than $50,000. Also, be aware that you don’t have the opportunity to borrow what you invest in company matching funds. You can only borrow from what is personally deposited and what you invest periodically over time.
- Payment terms: For the most part, a 401k loan has a 5-year payment term. The interest rates are at prime rates with an additional 1%. If you decide to borrow to buy a home, longer payment terms are available.
- Fees to process your loan: In order to process your loan, lenders require a fee upfront. The amount can range from $50-$100.
Don't forget to look into the provisions and stipulations before taking out a 401k loan with the company you are in association with.
Do 401k loans affect credit?
401(k) loans do not involve credit checks, hence it does not affect your credit. Once you get approved for a 401(k) loan, the new loan will not appear on your credit report.
Also, the plan administrator will not report your loan payments or defaults to credit bureaus. You can get approved for a 401(k) loan even with poor credit.
Do 401k Loans Have Interest?
401(k) loans charge an interest that is paid back to the participant's account. It is lower than the interest charged on bank loans, and it is set at one to two points above the prime rate. For example, if the prime rate stands at 4%, the interest rate can be 5% or 6%.
However, this interest is not considered a “true interest”, since it is not a borrowing expense. Instead, it involves transferring money from one of your pockets to another.
How Fast Can I Get a 401k Loan?
If your 401(k) plan has an online application process, the loan processing time can take less than a day, and another 2 to 3 days to receive a direct deposit. If you fill out manual paperwork, it can take up to 10 days to receive your loan.
Generally, a 401(k) loan has a quick approval process since it does not involve credit checks, and you can get approved as long as you have a sufficient 401(k) balance.
How Much Can You Borrow?
Trying to determine the amount you can borrow from your 401k can be difficult to determine. Here’s a brief summary.
If you didn’t borrow against your 401k in the past 12 months, you can borrow the lesser of the following:
- 50% of the amount you have put towards your 401k balance. If the amount is less than $10,000, you have the option to borrow up to $10,000. You just can’t borrow more than your total account balance.
This may seem like a cakewalk, but it’s not. Here’s why…
If you withdrew from your 401k within the past 12 months, the amount you can borrow decreases by the largest balance you had within that period.
Come on and let’s look at some examples of this:
- Example 1: Baruch has $30,000 in his 401k. He hasn’t had a 401k loan balance within the past 12 months. Baruch has the option to borrow up to $15,000.
- Example 2: Fred has $25,000 in his 401k. Fred also had a 401k loan balance of $5,000 within the past 12 months. He can borrow up to $7,500.
- Example 3: James has $250,000 in her 401k. She hasn’t had a 401k loan balance within the past 12 months. Rivi has the option to borrow up to $50,000.
- Example 4: John has $17,000 in her 401k. In addition, he hasn’t had a 401k within the past 12 months. Moreover, he can borrow up to $10,000.
How Are 401k Loans Repaid?
The IRS requires borrowers to pay the 401(k) loan in substantially equal installments spread over a 5-year period, or more if you are borrowing to buy your primary residence. You pay the loan through payroll deductions, where the employer automatically deducts periodic loan payments from your salary. If the employer allows payments through checks, you can make check payments at least every quarter until the loan is fully paid off.
If you quit your job, you may be required to pay off the outstanding 401(k) loan fairly quickly, before the tax due date for tax returns in the following year.
What Happens to 401k Loans When You Change Jobs?
If you change jobs, you must pay back the outstanding 401(k) loan fairly quickly. You may be allowed up to the tax due date for federal tax returns to pay off any outstanding loan balance.
If you can’t repay the loan by the tax due date, the outstanding loan balance will be considered a distribution, and you will owe taxes and a potential 10% early distribution penalty if you are younger than 59 ½.
401(k) Loan Taxes
Now check this out. When you initially take out a 401k loan, you don’t pay taxes on the amount you receive. The not-so-good part about this is if you don’t repay on time, taxes and penalties are due. If you transition out of your employment with having a 401k loan, the people behind the system consider it a distribution at that moment. This won’t be so if you repay it all back within 60 days.
If you don’t repay the loan in accordance with the term given, anything else remaining is a distribution.
As a result, this becomes your taxable income. If you’re under the age 59 ½, the big wigs will apply a 10% early penalty tax. 10% percent of loans transition to default because of job changes. To make matters worse, there are not enough resources to satisfy these loans.
Do 401k Loans Count as Income?
A 401(k) loan is not considered an income, hence it is not subject to income taxes. The amount taken out of a 401(k) as a loan must be paid back over time to restore the account to its original balance. If you pay off the 401(k) loan on time, you won’t owe any taxes.
However, if you default on the 401(k) loan, the IRS considers the unpaid loan as an income, and you will owe taxes on this amount. And this is what brings us to the next question.
What Happens If You Default on the Loan?
Defaulting on a loan happens when you don’t follow the terms of the loan. This means that you didn’t make your payments on time, or if you didn’t repay back the loan within 60 days of leaving the company.
As a result, the remaining balance counts as a distribution from your 401k. Here are the consequences that one would face:
- If you’re at the age of 59 ½ or meet other criteria, that amount of money is taxed with a 10% penalty.
- The amount that I default doesn’t qualify to roll over into an IRA or some other retirement plan. As a result, there’s no way to avoid the taxes and penalties.
The cool thing is that defaults aren’t reported to the credit bureaus. This means that it doesn’t have an impact on your credit score, like other loan approvals. On the hand, if you’re applying for a personal loan, lenders have the right to ask you about any 401k loan defaults. They will consider this while making a decision.
How Do You Apply for a 401k Loan?
If you got money in your 401k, the loan application process is a breeze.
Other than knowing the restrictions (see above), all you have to do is request a loan. You can apply online or through your human resources department if necessary.
Don’t worry; there are no credit checks for those who apply for a 401k loan. As a result, it’s easier to get this type of loan. Another advantage is that these loans have to be available to all employees. This means that you qualify for approval no matter the position you have with the company you work for.
Here's a summary of the main pros & cons (click to see explanation or scroll down):
|A Small Amount of Paperwork Only Needed||Defaults, Penalties, and Taxes|
|Paying Yourself Interest||Fees|
|Easy Repayment||Money Taxed Twice|
|Lost Retirement Gains|
|Transitioning to Another Job or Being Fired|
Pros of 401(k) Loan
I’m not a big fan of 401k loans because they short-circuit the gains that are long-term that you could have for retirement. On top of that, they carry a big risk. Even though this is true, there are some circumstances where I may take out one.
Here’s a great example:
If you have to pay a large sum of money to the IRS, getting a 401k loan is a better option than getting in trouble with the IRS.
I mean… you don’t want to go to prison, right? Being at risk of foreclosure or losing your vehicle to the repo-man are other reason why you may want to consider a 401k loan. Be aware that there are risks involved.
Let’s take a look at some of the reasons why getting a 401k loan can be a good thing.
- A small amount of paperwork only needed: Normally, very little paperwork goes into applying for a 401k loan no matter if you need it or not. For most people, it’s as easy as applying online or making a quick phone call. The only time they may inquire more information is if you’re applying for a mortgage.
- Paying yourself interest: When you apply for a loan or credit card, you have to pay the bank interest. Regarding a 401k loan, you pay yourself interest. How sweet is that!
- Easy repayment: Most of the time, the 401k loan repayment is taken out your check directly. This is super beneficial because it makes paying back your loan a cinch. Since it comes out of your paycheck automatically, you don’t feel the loss of losing money.
Even though I’m not fond of 401k loans, they can be a good alternative to standard loans if you find yourself in a dire financial situation. As I state, there are advantages to 401k loans, but there are risk factors as well, which we are about to dive into next.
Cons of 401(k) Loan
There are a lot of risks that accompany 401k loans. If you aren’t wise, you may suffer serious consequences.
- Defaults, penalties, and taxes: If you default in your loan for whatever reason, you will have to pay taxes on it at the normal rate. On top of that, you have to pay a 10% early withdrawal penalty. This means that you may have to pay a big tax payment during tax season. Moreover, most people aren’t prepared for it because people typically spend the money beforehand.
- Fees: If you’re not observant, you could be losing money to various fees. You may have to pay loan origination fees as well as an annual maintenance fee. For instance, if you got a $1000l loan with a $75 origination fee and a $25 maintenance fee on a 5-year loan, you’ll have to pay $200 in fees or 20%. That’s a lot of money to dish out all at once. Always be aware of the fees that accompany your 401k loan plan.
- Money taxed twice: As you begin to pay back your 401k loan, you’re using post-tax funds to do so. Because the money is going right back into a pre-tax account, it will be taxed again when a distribution is taken during retirement. That’s what you call double taxation!
- Lost retirement gains: If you begin to take out money out of your 401k, you are also losing any gains that you would have had if you didn’t. The price you pay is even greater if withdraw while the market is down and it isn’t returned to your account until the market rises again. So here’s the point: you miss out on any gains your money had the potential of making.
- Transitioning to another job or being fired means loan comes due: If you transition to another job or got let go, your 401k loan becomes due immediately. The good thing about it is that there’s usually a 60-90 grace period. If you don’t pay back the loan on time, you’ll have to pay a 10% penalty as well as your normal tax rate equivalent to a normal default. Moreover, it means you could see 35%-40% in taxes and penalties. When tax season rolls around, you have to pay a lot of taxes at a time when you don’t want to lose more money!
The reality is this. There are more cons regarding 401k loans than there are pros. There are many risks that accompany the fees charged, penalties when you change or lose your job, and losing investment gains. As you can see, this is something very serious to think about.
401k Loan vs Personal Loan: Which Is Better?
A 401(k) loan is a loan that is secured by the balance of your retirement account, while a personal loan is an unsecured loan from a bank, credit union, or other lenders.
A personal loan could be a better choice if you have a good credit score to qualify for the lowest interest rates. You can also take a personal loan if you are borrowing no more than a few thousand dollars.
Overall, if you can get low-interest rates on your loan and you don’t expect to have difficulties in making loan payments – a personal loan might be a better option since it's recommended to avoid taking out funds from your retirement. 401(k) loan could be a better option if you have a poor credit score that prevents you from getting a fair interest rate for your personal loan.
401k Loan or Home Equity Loan?
If you are borrowing for an urgent financial emergency, a 401(k) loan may be a better option since it has a quick turnaround, has a lower interest rate, and there are no credit checks involved. However, taking money out of your retirement account denies your retirement money an opportunity to grow through compounding.
If you are looking to borrow several thousand dollars, you should consider taking a home equity loan. A home equity loan taps into your home equity. It has flexible repayment terms and you can lock in a lower interest rate. A home equity loan has a longer repayment period, and you can spread repayments over several years to lower the monthly bill.
If you have a financial emergency, a 401(k) loan can be a better option than taking a bank loan due to the quick approval process. A 401(k) loan does not involve credit checks, and you can receive your money in days. Also, it charges a lower interest rate than a bank loan, and this interest goes back to your 401(k) account.
On the downside, tapping into your 401(k) retirement savings is considered a bad idea since it could jeopardize your retirement income. The money borrowed from your 401(k) will no longer grow tax-deferred, and your money will not earn an investment return. Overall, do your best to avoid 401k loans and use another source of money.
The government cannot garnish your 401(k) to pay a defaulted student loan. 401(k)s enjoy creditor protection, and the ERISA act bars creditors from seizing the assets of a 401(k) participant. This is because the money held in the 401(k) does not fully belong to you until you withdraw it. Your 401(k) may only be garnished if you owe federal tax liens.
Since a 401(k) is considered marital property, any liabilities such as 401(k) loans are also considered marital debts. Therefore, any outstanding 401(k) loans should be shared during a divorce to ensure equitable distribution.
As long as the 401(k) was taken during marriage, the outstanding balance should be shared equitably between spouses. However, if the loan was taken after separation, the outstanding loan will be borne by the 401(k) account owner.
Most employers allow only one 401(k) loan at a time, and you must repay the loan in full before taking another 401(k) loan.
However, some employers may allow multiple 401(k) loans as long you don’t exceed the maximum loan limit i.e. half of your vested balance up to a maximum of $50,000. You must make loan payments to both 401(k) loans at the same time to avoid defaults.
A 401(k) loan does not count when calculating your debt-to-income ratio or credit score, hence it won’t affect your chances of qualifying for a mortgage loan. You can take a 401(k) loan to pay down payment for your home.
However, the mortgage lender may require you to disclose your current monthly obligations, including 401(k) loans, when applying for a mortgage.
If you have an unpaid 401(k) loan when you retire, you must pay back the loan by the tax due date in the following year. You can make loan payments via check.
However, if you are unable to pay off the loan, the loan will be considered to be in default, and the plan may offset your loan balance against your retirement savings to recover the unpaid loan. The loan offset will be considered a distribution that is subject to income taxes.