Understanding the Basics of 401(K) Loans

Understanding the Basics of 401(K) Loans

Taking a loan against your 401(K) account may not be the best thing you do, especially if you do not have any other savings for your retirement. However, in case of a financial emergency, you may find a 401(K) loan more convenient as compared to loans offered by banks. Having said that, you should know the basics of 401(K) loans before making a decision.

Legal Limit
401(K) has set legal limits on borrowing, and you can borrow a maximum of $50,000 or 50% of the account balance, whichever is less. The balance in a 401(K) account belongs to you, but you cannot withdraw them before retirement and are liable to pay a 10% penalty on the amount if you make an early withdrawal.

The loan is repaid through automatic monthly or quarterly deductions from payroll, and the installments are deducted from the paycheck after taxes. The longest term of repayment is 5 years, but there may be exceptions for people who have bought a new house. Some 401(K) accounts do not allow you to plan the loan repayments, and if you lose your job before the loan is cleared, you need to repay it immediately. Otherwise, it may be labeled as an early withdrawal and may lead to a penalty and taxes from the IRS.

Interest payment
Another basic concept of 401(K) loans is that the interest rate depends on the rules of your plan. Additionally, although the interest is repaid into your own account, your retirement savings take a hit when you take a 401(K) loan.

Provision to borrowing

  • 401(K) has various plans, among which some allow withdrawals in the form of a loan while others do not. You must check with your investment company or plan administrator to find out if you can borrow against your 401(K) account. Many plans allow for multiple loans, while some do not allow any, depending on the rules for the plan set by an employer.
  • If you are not working for the company where you have a 401(K) plan, you cannot take a loan. You can transfer the balance from an old 401(K) plan to a new one then take a loan if your new employer allows. If you transfer the funds from your old 401(K) account to IRA, you cannot borrow from it. So, you must understand the basics of 401(K) loans before you transfer or take cash from an old 401(K) plan.

Late repayments
You do not have to pay taxes on the amount you receive, but penalty and taxes are levied if the loan is not repaid on time. If you leave the job before you repay a 401(K) loan, it is considered a distribution unless you repay it immediately. If you are under the age of 59 and 1/2 years old, you may face a 10% penalty fee in such cases.