How Do 401(K) Loans Work?

When individuals are in a tight spot financially, they often turn to 401(k) loans. The interest rate for the 401(k) loans is 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).

The Pros and Cons

Like any other type of debt, there are pros and cons involved in taking out a 401(k) loan. Some of the advantages include convenience and the receipt of the interest paid. For example, if you take out a 401(k) loan and you pay 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 time 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 grace period, 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 59½. 

More to Consider

Here's an important point to consider. Previous terms and conditions allowed account holders to access certain 401(k) loans using their credit or debit cards. But plan administrators are no longer permitted to allow this option under Section 108 of the SECURE Act, also referred to as the Setting Every Community Up for Retirement Enhancement Act.

The act was signed into law on Dec. 20, 2019, as a way to help boost the landscape for retirement benefits in the United States and strictly prohibits the use of credit cards and other similar vehicles to access loans made through 401(k)s.

Advisor Insight

Timothy Baker, CFP®, MBA
WealthShape LLC, Windsor, CT

This may sound like a good option for those in need of funds but there are a few things to consider.

The loan will have interest attached to it. While that interest payment does go back into your account, consider the opportunity cost of what you could have earned if the loan amount was invested.

Depending on the stipulations of your 401(k) plan, you may or may not be able to make additional contributions while you’re in the process of paying back your loan.

Other options to consider are hardship withdrawals, though they have significant conditions according to the IRS code, or a home equity loan.

Another possibility is taking a series of equal periodic payments, which can help to avoid the 10% early withdrawal penalty. Withdrawals must last a minimum of five years or until age 59½.

Article Sources
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  1. Internal Revenue Service. "Retirement Plan FAQs Regarding Loans."

  2. Fidelity Investments. "Thinking of taking money out of a 401(k)?"

  3. Internal Revenue Service. "How Do 401(K) Loans Work?"

  4. United States Congress. "H.R. 1994 -- Setting Every Community Up for Retirement Enhancement Act of 2019: Section 108."

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