One of the nice things about some 401(k) plans is that they come with the option of taking out a loan. After all, there may be times where you are short on cash and could really use the money in your 401(k) for a down payment on a house, car, or some other purchase.
I personally have gone through the process of taking out a 401(k) loan to pay off an unexpected large tax bill. Going through that process I became aware of both the pros and cons of taking out a loan on your 401(k).
Ultimately it’s important to understand 401(k) loan rules before deciding whether or not to take out a 401(k) loan.
Who can take out a 401(k) loan?
401(k) retirement accounts are administered by employers. Employers do not have to offer their employees the option of taking out a loan against their 401(k). After all, it’s an added expense to the employer. Many large employers – and quite a few small- to mid-size employers do offer the option, though.
Employers also may limit when you can take out a 401(k) loan. Some only allow it for specific purposes such as the purchase of a first home or to pay medical bills. Others make no such limitation on their loan program and allow employees to take out a 401(k) loan without providing a specific purpose for the loan.
401(k) Loan Rules
As you might imagine, 401(k) loan rules will vary by employer. They typically have many similarities, though.
For example, most plans will require employees to pay back the loan in full within a specified period of time (i.e. 30, 60, or 90 days) if they leave the employer for another job or are laid off. If they do not pay back the loan in full they will be required to report the loan as taxable income plus pay the standard 10% penalty for early withdrawal of 401(k) funds.
401(k) loan rules typically allow for a loan worth 50% of the current market value of a 401(k) account. They also typically allow for a maximum loan of $50,000. Another common 401(k) loan rule is that only 2 loans may be taken out at a time.
There is a flat fee for setting up the loan and the “interest” on the loan goes back into the borrower’s 401(k) account. This makes a 401(k) loan more attractive than other loan options borrowers face because they do not lose money from interest payments. Instead they pay themselves the interest and only miss out on the gains that their 401(k) investments would have generated.
Pros and Cons of 401(k) Loans
As one might expect, taking out a loan against a 401(k) has both pros and cons. Some of the favorable things about 401(k) loans are:
- Easy Access to Funds – Instead of going through the personal loan process which will scrutinize borrowers to a great degree and typically come with relatively high interest rates, 401(k) loans offer borrowers easy access to funds for a home down payment, car, or other financial need.
- No Early Withdrawal Penalty – When someone withdraws funds from a 401(k) before they reach retirement they not only have to report the withdrawal as taxable income, they also are required to pay a 10% penalty. 401(k) loans allow investors to “withdraw” funds and bypass both of these early withdrawal requirements.
While 401(k) loans provide borrowers with easy access to funds without paying interest to a third party and the ability to bypass early withdrawal penalties, there are some trade-offs when taking out a 401(k) loan. They include:
- Missing out on Investment Gains – One negative to taking out a loan against a 401(k) is that the borrower potentially misses out on investment gains. The balance of the loan is no longer exposed to the stock/bond market. As the loan is paid back, the amount paid back is once again exposed to the market. The risk is that a loan will be taken out when the market rises, therefore costing the borrower investment gains.
- Employment Change Forces Quick Repayment – The other big negative to 401(k) loans is the fact that an employee must repay the loan in full within a very short period of time if they switch employers and/or become unemployed. This is due to the fact that employers are paying third-party companies to service 401(k) loans. If someone is no longer an employee, they no longer have access to this benefit. The full loan must be paid back within 30-90 days or the borrower will be faced with a 10% penalty and required to report the loan as taxable income.
Hopefully this post shed some light on 401(k) loan rules and gave you a better understanding of how 401(k) loans work. The important takeaways are to check with your employer as to whether or not you qualify for a 401(k) loan and be aware of both the pros and cons of taking out a 401(k) loan.