401(k) Loans: How They Work and are They Right for You

A 401(k) loan can be a quick way to get some cash. When you’re in a financial pinch, it is a low-interest alternative to using a credit card or personal loan. You might use the funds to pay bills, cover a big purchase, or put a down payment on a house.

However, 44% of people who’ve borrowed against their retirement savings regret the decision, according to TIAA-CREF. If you’re considering a 401(k) loan, here’s what you need to know about how it works and how the temporary 401(k) loan Covid rules from the CARES Act could impact you.

How a 401(k) loan works

A 401(k) loan is when you borrow money from your 401(k). Even though you’re essentially borrowing money from yourself, you’ll pay interest and have loan terms and a repayment schedule to follow

However, not all 401(k) plans allow you to borrow from your account—some programs don’t allow it. Review your plan documents or ask your human resources department if you’re not sure. If your plan allows 401(k) loans, you must understand the borrowing limits, maximum repayment term, and other pros and cons before you apply.

How much can you borrow from a 401(k)?

Under normal circumstances, the Internal Revenue Code from the IRS allows you to borrow up to half of your vested plan balance but not more than $50,000. For example, if half of your vested balance is $70,000, you could still only borrow up to $50,000.

There is one exception: You can borrow up to 100% of your funds if your vested account balance is less than $10,000.

Congress doubled the amount you can borrow when they passed the CARES Act. If you’ve been affected by coronavirus, you can borrow the lesser of 100% of your vested balance or $100,000 with a 401(k) loan.

So, how many loans can you take from your 401(k)? Even without the generous flexibility from the CARES Act, your employer may let you take out more than one 401(k) loan. However, the total amount you borrow can’t exceed the maximum allowed by the IRS.

401(k) repayment rules

How long you have to repay your loan depends on why you took it out in the first place. Generally, the IRS sets the maximum repayment term:

● 5 years

● More than 5 years if you use the funds to purchase a house

You must make at least one payment every three months. Although, monthly or weekly payments are often easier to manage than a single lump sum each quarter. Your loan could be labeled as a distribution if you don’t make on-time payments. Distributions have two primary disadvantages:

● You’ll likely have to pay income tax on the amount

● You’ll pay a 10% early distribution tax if you’re under the age of 59 ½

You must also consider the interest rate. For most 401(k) loans, you’ll pay a point or two above the prime rate, but it can vary. The prime rate was 3.25% as of July 2021, so your rate could fall between 4.25% and 5.25%.

The interest you pay on a 401(k) loan goes back into your 401(k). So, unlike with a personal loan or line of credit, you’re paying yourself interest.

Your repayment timeline could be cut short if you leave the company. If you’re terminated or quit voluntarily, you may be asking, “Can I borrow from my 401k if I no longer work for the company?” No, and you may need to repay the loan immediately when you leave your employer. If you don’t have the cash on hand to cover the balance, your employer will report it as a distribution—and that could result in tax consequences.

401(k) loan advantages

Interest rates, taxes, and fees are a few of the wildcards you’ll face with any loan, and a 401(k) loan is no exception. Still, many advantages exist that make borrowing from you 401(k) an attractive option:

● It’s fast—you could have the funds in about 7 to 10 business days.

● It can replace a gap in income if you’re short on cash flow.

● It isn’t subject to taxes as long as you pay back the loan on time.

In most 401(k) plans, taking a loan is quick and easy. It doesn’t usually require a credit check or a lengthy application. The cash can help pay an unexpected expense, down payment to buy a house, or monthly bills if you’re short on funds. It can also save you from paying tax penalties that come with a hardship withdrawal, where you take out the money without needing to pay it back.

Before deciding to take a loan against your retirement, keep in mind the downsides to taking out a 401(k) loan—your plan may not allow it, you may not be able to access as much cash as you need, and you could face tax consequences if you don’t stick to the 401(k) loan repayment rules.

Borrowing with a 401(k) loan is a decision that shouldn’t be taken lightly. Talk to a financial planner about how it could impact you. We’ll help you discover if a 401(k) loan is the right option for your situation.

Andrew Comstock, CFA