How Do 401K Loans Work?

by Karen Farnen

A 401(k) loan provides a quick source of emergency money for many employees. Americans are especially prone to borrow from retirement accounts when home equity credit lines get frozen and credit card limits are cut. According to MSN Money, nearly 30 percent of those with 401(k) plans owed their accounts money in mid-2011. Employers often make borrowing from a 401(k) simple and convenient. However, 401(k) loans also have their downside.

Borrowing Requirements

The Internal Revenue Service permits borrowing from a 401(k) if your employer's plan allows it. However, you must follow both the IRS and plan rules. Normally you can borrow up to a limit of $50,000 from your employee contribution, but not from the income. The loan also cannot exceed 50 percent of the amount vested in your account. Carrying another 401(k) loan balance the previous year further reduces your maximum amount. This is true only if the loan is from the same employer or an affiliated one. Usually, married borrowers need spousal consent to get a 401(k) loan. Employers also sometimes restrict loans to specific purposes, such as a home purchase, medical bills or education.

Repayment Requirements

The IRS requires repaying 401(k) loans in substantially equal amounts. You must make payments quarterly or more often during the life of the loan. You have to repay the loan completely in five years unless it is for the purchase of your principal home. Employers generally make repayment easy and automatic by deducting the payments from your paycheck.

Advantages

A 401(k) loan application is usually simple, with no credit check requirement. Many employers do not even restrict your reasons for borrowing. Although you have to pay interest, the interest goes back into your own account. In addition, a 401(k) loan normally carries a lower interest rate than a credit card loan, frequently the prime rate plus 1 to 2 percent. If you happen to borrow right before a drop in the investment markets, you avoid losses. For example, those who borrowed from their 401(k) accounts in 2007 in effect "sold high." They maintained gains that would have disappeared in the 2008 market fall.

Disadvantages

The IRS recommends considering other possibilities before borrowing from your 401(k). This is because a loan can reduce your account growth and thus the money available when you retire. If you fail to pay on time, IRS rules require paying income taxes on the unpaid amount. You must also pay a 10-percent early withdrawal penalty if you have not reached age 59 1/2. The worst scenario occurs if you leave your job for any reason, even for retirement or a layoff. Employers usually require you to pay back the entire loan in 60 to 90 days after you leave.

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