How do 401(k) loans work?

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August 2016
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Ideally when you need to borrow, the emergency fund you set up at the bank should be the first place to go.  Any borrowing from the retirement account should be the last resort unless you absolutely have to because you’re literally “stealing” from your future fund, paying a current price (via interest & fees), and possibly facing some tax consequences.   

A loan option is not available for every 401(k) plan.  Some allow it; some don’t.  Hence, you must peruse your employer’s 401(k) plan summary to find that clause.  Secondly, don’t get too excited as there’s a limit on how much you can borrow.  If you have not borrowed any loans in the 12 month period ending on the day before you apply for a loan, you are allowed to borrow up to 50% of your vested account balance to a maximum of $50,000. Third, nothing is for free even if you borrow from yourself.  This is actually good because you are paying yourself the interest, which is the "prime rate" plus whatever your employer decides.  Say, looking up the WSJ, you see the “prime rate” is 3.5%, and your employer requires another 2%.  Consequently, you will pay 5.5% interest for the loan you borrow.  Lastly, try to hang on your job while you have the loan as the layoff can have some negative impact on your borrowing. Either you pay back immediately within 60 days of termination of employment, or you risk the loan being considered defaulted and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½.  So, think carefully before borrowing from your 401(k).  Best.

April 2009
August 2016