How do 401(k) loans work?
When individuals are in a tight spot financially, they usually turn to 401(k) loans. The interest rate for the 401(k) loans are usually a point or two higher than the prime rate, but they can vary. By law, individuals are allowed to borrow the lesser of $50,000, or 50% of the total amount of the 401(k).
Like any other loan, there are pros and cons involved in taking out a 401(k) loan. Some of the advantages include convenience and the recipient of the interest paid. For example, if you take out a 401(k) loan and you are paying 12% interest on it, that 12% is going back to your 401(k) because that is where the money is from. One major disadvantage of a 401(k) loan is the loss of tax sheltered status in the event of a job loss. If you take out a loan on a 401(k) and you lose a job or change jobs before the loan is fully repaid, there is a 90 day period in which the full amount of the loan is to be repaid. If the loan is not fully repaid at the end of the 90 days, not only does the amount become taxable, an additional 10% penalty is charged by the Internal Revenue Service (IRS) if you are under the age of 59.5. (For more on 401(k) plans, read our article: The 4-1-1 on 401(k)s.)
This question was answered by Chizoba Morah
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.
This may sound like a good option for those in need of funds but there are a few things to consider.
Opportunity Cost: The loan you take will have interest attached to it. While that interest payment does go back into your own account, you should consider the opportunity cost of the amount you could have earned if the loan amount was otherwise invested vs. the amount you earn on the interest from the loan repayment. Usually your plan will allow for access to 50% of the balance in your 401(k) or $50,000, whichever amount is smaller.
Additional Contributions: Depending on your employer and the stipulations associated with your 401(k) plan, while you’re in the process of paying back your loan you may or may not be able to make additional contributions. Also keep in mind that normally the way the loan repayment works is via a reduction in your post tax take home pay.
Job Loss: Usually the plan will require you to pay back the loan within a 60-90 day window following separation. Failure to repay could result in a 10% early withdrawal penalty.
Hardship Withdrawals: 401(k) plans do allow for hardship withdrawals for immediate and heavy financial burdens such as medical costs, funeral expenses, principle residence purchase or foreclosure prevention etc. However, in most circumstances, a 10% early withdrawal penalty will apply for anyone under 59.5. There are some significant conditions according to the IRS code to take into consideration: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-hardship-distributions
Home Equity Loans: Home equity loans can also be a source of funding to consider. While this does add to your overall debt, the interest on the loan may be tax deductible.
IRA 72(t) Withdrawals: If you have an IRA, 72(t) withdrawals may also be a possibility. This option can help to avoid the 10% early withdrawal penalty prior to age 59.5. However, distributions must be taken in a series of equal periodic payments. These payments have to last for a minimum of 5 years or until age 59.5. They take whichever period is longer. https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-substantially-equal-periodic-payments