What is a 401(k) loan?
A 401(k) loan is money borrowed against a 401(k) retirement savings plan. Borrowing from your own 401(k) does not affect your credit score and does not require a credit check as the remaining assets in the account are used as collateral. For plans that allow loans, the loan must be repaid with interest within a specified time frame.
THE CENTRAL THESIS
- Some employers allow participants to borrow against their 401(k) accounts, but there are limits to the amount.
- A 401(k) loan does not affect the borrower’s creditworthiness and does not require a credit check.
- If you default on the loan, you will have to pay income tax on the withdrawn money and may also be subject to a prepayment penalty.
- Depending on the plan, a borrower may not be able to make contributions if they have an outstanding loan.
How a 401(k) loan works
For critical short-term needs, borrowing from a 401(k) account may be a better choice than a hardship withdrawal permitted under certain circumstances or a high-interest bank loan. Any money borrowed from a 401(k) account is tax-free as long as you pay back the loan on time. And you pay the interest to yourself, not to a bank.
You don’t have to claim a 401(k) loan on your tax return. As long as the loan is repaid on time, the only tax consequence is the interest associated with certain plans. The term “interest” is somewhat misleading as funds are returned to the participant’s own account.
The borrower must use post-tax dollars to repay the loan including interest. This means that part of it is taxed twice by the state. Income tax is paid back on the amount when the retired borrower taps the account. However, 401(k) interest rates are typically modest, so the double taxation impact is negligible. It is only relevant if the loan amount is large and will be repaid over several years.
The IRS allows a loan of $50,000 or 50% of your balance, whichever is lower. An exception is when the balance is less than $10,000. In this case, you can borrow up to $10,000 provided the value of the credit account is at least $10,000. Each plan has its own credit limits and does not have to offer them at all. So check with your employer for details.
On March 20, 2020, former President Trump signed a $2 trillion emergency aid package. It doubled the amount of 401(k) money available as a loan to $100,000, waived the 50% outstanding balance limit, and dropped the prepayment penalty if you died before age 59.
As an example (using the traditional rules), if your balance is $15,000, you can borrow $10,000 since 50% is only $7,500. However, if your balance is $120,000, you can borrow a maximum of $50,000. With the introduction of the CARES Act, you could borrow $100,000 of that $120,000, but only if you
Failure of a 401(k) Loan
The tax ramifications are significant for borrowers who default on a 401(k) loan. Except in 2020 for those affected by the crisis, those under the age of 59 must pay a 10% prepayment penalty on the outstanding balance in addition to paying income tax.
Let’s say you’re under 59, arrears on a loan with an outstanding balance of $10,000, and have an effective tax rate of 15%. When you file your annual tax return, you owe the government $1,000 in prepayment penalties and another $1,500 in income tax (which would otherwise be deferred until retirement). Within a year, that $10,000 will be reduced to $7,500.
The 401(k) credit risks
Some plans do not allow participants to make plan contributions if a loan is outstanding. If it takes you five years to repay the loan, you’re not saving anything on your 401(k). It also means that you will not enjoy the tax benefits of depositing money into your retirement account.
You also miss out on any counter-contributions that your employer could make while the loan is being repaid.
The 401(k) loan vs. payout
It is important to determine your ability to repay a 401(k) loan before proceeding. Most planners recommend keeping your nest egg intact unless you can no longer pay your rent or mortgage, utility bills, or groceries, for example.
In short, if you need money and are confident that you can pay back the loan, the minimal tax consequences and the ability to fund your account with interest can make these loans a viable option.
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