First and foremost, your 401(k) is for your retirement. However, if you have a unique and specific need for a short-term loan, your 401(k) may be a good source of funds. However, the ability to borrow from your 401(k) should not be considered a piggy bank that can be tapped when needed.
The IRS allows participants of qualified plans, such as a 401(k) or profit-sharing plans, qualified annuity plans, 403(b) plans and some governmental 457(b) plans, to take loans from their plan balance. In general, you can borrow the greater of $10,000 or 50% of your vested account balance, up to $50,000. The IRS requires repayment of the loan within five years. Loans taken to purchase your principal residence may be repaid over a longer period. Generally, payments must be made at least quarterly in substantially equal payments that include principal and interest.
Qualified plans are not required to allow loans. Specific loan terms are governed by your plan’s documents, which define the plan’s rights and obligations for the participants and beneficiaries. Your plan may further restrict the conditions for a loan, such as only offering loans under a proven hardship.
Employer-sponsored retirement plan loans offer several advantages. You may automatically qualify as a plan participant. Plan loans are available with little to no cost other than modest origination or administration fees. The borrowing process is usually easy and private, as you can often request the loan through your plan administrator’s website. Additionally, the interest rate is usually favorable, commonly one or two points above the prime rate of lending. Any interest paid on the loan will go into your account balance.
It is highly recommended that a loan from an employer-sponsored retirement plan be for a short-term need, usually a year or less, despite the generally allowed five-year repayment period. It is also best if you know in advance when you’ll be able to repay your loan. The minute you take money out of your plan, you will miss the opportunity for tax deferred investment earnings. You also need to understand that you will pay back the loan and interest with after-tax money. While the interest is paid to yourself, you will be taxed again on that money when you withdraw those funds in retirement.
If the plan guidelines are not followed, the loan may be treated as a taxable distribution. If you are younger than 59 ½, the distribution will be subject to the 10% early withdrawal penalty. Likewise, if you terminate employment with your company, your plan may require you to repay the loan in full within a short period of time. Specific repayment requirements when leaving your employer’s service will be outlined in your plan’s documents, so it is advisable that you understand the terms thoroughly before borrowing. Any failure to repay the loan will trigger tax consequences.
Employer-sponsored retirement plan loans can be very favorable for short-term cash needs, providing you can fulfill your obligations to the loan. But remember, just because a plan allows loans doesn’t mean it is always a good idea, as this money is specifically to fund your retirement.
If you have questions on how a 401(k) loan will affect your overall financial plan, the experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
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