25 Sep 401(k) Loans – FAQs
How do 401(k) loans work?
Whereas with a traditional loan you make payments to a lender, with a 401(k) loan you are borrowing from your own account. Loan payments (interest and principal) are paid by the borrower back to their own account, and are typically handled through payroll deductions. The amount borrowed is tax-free, but becomes subject to tax and penalties if repayment is not made according to the plan terms.
Many 401(k) loan features are specific to a plan and are detailed in the plan’s Summary Plan Description (SPD).
Is my 401(k) plan required to offer loans?
No – although most 401(k) plans do offer loans to participants, it is not required that they do so. Additionally, the terms of 401(k) loans can vary substantially between plans, as you’ll see from some of the other questions.
How much/how long can I borrow using a 401(k) loan?
While a plan may have lower borrowing limits, IRS rules limit the maximum 401(k) loan amount to the lesser of:
- The greater of $10,000 or 50% of your vested account balance
The maximum loan amount may be further reduced if you have had an outstanding 401(k) loan in the prior 12 months.
The maximum loan term is typically five years, but an exception exists for the purchase of a primary residence that extends the maximum loan term.
How is interest on a 401(k) loan handled?
Interest rates for 401(k) loans are set by the plan, but are typically significantly lower than market lending rates. Many people convince themselves that 401(k) loans are advantageous because you are borrowing at a low rate and paying interest to yourself rather than to a lender.
However, this is short-sighted. The interest you pay back to your 401(k) account is after-tax income, but will be taxed when it is ultimately withdrawn from the plan, meaning you are taxed twice on the amount. Perhaps more importantly, there can be a substantial opportunity cost to borrowing from a 401(k), since the interest paid is likely to be significantly less than potential investment returns. Finally, unlike a traditional mortgage, interest paid on a 401(k) loan used for a home purchased is not deductible.
What happens if I leave my employer while I have an outstanding 401(k) loan?
When you leave an employer, any outstanding 401(k) loan balance becomes due, although the recent tax reform has provided some additional flexibility on the timing of the repayment. Failure to repay the loan in the required time period results in the outstanding loan balance being treated as a withdrawal, which is subject to tax and potentially a 10% penalty. While you may not plan to leave an employer during the loan term, recognize that unforeseen situations may occur.
Do other retirement plans have loan options?
Similar to 401(k) plans, profit-sharing, 403(b) and 457(b) are allowed to offer loans to plan participants.
Loans are not permitted from IRAs or IRA-based plans, including SEPs, SARSEPs and SIMPLE IRAs.
Should I use a 401(k) loan for _____?
We typically strongly advise clients to avoid taking 401(k) loans. In short, the purpose of your 401(k) is not to provide an inexpensive source of funding, but to provide the basis for your long-term retirement needs. Borrowing from your 401(k) reduces the invested balance, impeding the growth of the account. Compounding the issue, a recent survey by Fidelity found that 401(k) participants with plan loans had significantly reduced contributions (or stopped contributing completely) compared to those without loans.
While we usually suggest borrowing from a 401(k) only as a “last resort”, we acknowledge that each situation in unique and that there may be times when borrowing from a 401(k) can make sense. If you would like help in determining if a 401(k) loan is appropriate for you, or what your alternative options may be, please contact us!