401(k) Loan Withdrawls: Limits, Conditions & Considerations

Are You Considering Borrowing Against Your 401(k) Account?

We all know the importance of planning for the future, and for many people that means participating in a workplace sponsored 401(k). It's frankly one of the easiest, and most effective, ways to save for your retirement. But many 401(k) plans can do more than just provide for your golden years. A growing number of programs allow participants to borrow against the equity in their 401(k)s, providing low cost loans that can be a real boon in a financial emergency. Of course, borrowing from your retirement savings is never an ideal situation, but in a crisis it is an option to be considered. That being said, there are some pitfalls to avoid if you are thinking about a 401(k) loan, and it is important to understand the pros and cons of borrowing from your retirement fund before you get in over your head.

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The Basics of 401(k) Loans

Every 401(k) program is different, and will have its own restrictions and requirements concerning loans. You should speak with your employer, or with the head of your firm's HR department, to learn how your retirement plan is managed and how it addresses short term lending. However, there are some basic features that are common to most (if not all) programs, and a short review should give you a general idea of how 401(k) loans work.

  • Minimum Loan Allowances – Most programs have a minimum loan amount. Typically, it will be around $1000. This can actually be somewhat beneficial, as it discourages employees from taking out multiple short term loans for more casual needs.
  • Maximum Loan Limits – Generally speaking 401(k) loans are limited to no more than $50,000 or 50% of the vested balance in your retirement fund. In most cases, you will only be allowed to borrow against the amount of money you have put into your 401(k), and not from the matching funds contributed by your employer.
  • Repayment Terms – Personal loans made against your 401(k) have a maximum repayment term of 5 years. Some programs do allow for extended home loans, but even then the repayment terms are fairly restrictive, typically being capped at 15 years.
  • Repayment Structure – With very few exceptions, payments on a 401(k) loan are deducted from your paycheck in equal installments until the balance is paid off. Keep in mind that this amount is over and above the regular contributions to your retirement fund.
  • Interest Rates – The interest on a 401(k) loan is calculated at a fixed rate. As a general rule interest is set at the current prime rate plus 1%.
  • Additional Fees – There are almost always additional fees and charges associated with 401(k) loans. These can range from nominal processing charges, to annual maintenance fees.
  • Taxable Proceeds – The proceeds from a 401(k) loan are tax exempt, assuming you repay the loan on time and in full. Should you default on the loan, it will be considered income and you will be required to pay taxes on the full amount.

The Benefits of a 401(k) Loan

While borrowing from your retirement fund isn't ideal, it does have a couple of distinct advantages over taking out a short term loan from a bank or credit union. In the first place, the application process is relatively simple, and in many cases can even be completed online. You only have to log into your account, fill out a form, and click a few buttons. If you are applying for a personal loan, you won't even be asked what the money is for. Once your loan is approved, you can even have the funds deposited directly into your bank account. Compared to traditional lenders, applying for a 401(k) loan is remarkably quick and easy.

The second most important benefit of a 401(k) loan concerns the interest. With a traditional loan the interest you pay goes directly to the lending institution. It's the price you pay for the luxury of borrowing money from a bank or credit union. However, with a 401(k) loan the interest you pay goes back into your retirement fund. Essentially, you are borrowing money from yourself and you reap the benefits of the paid interest. Keep in mind that while the proceeds of your loan are tax exempt, the interest on that loan is not. Still, the balance almost always works in your favor.

The Disadvantages of Borrowing from Your Retirement Savings

The advantages of 401(k) loans may be clear, but there are many disadvantages that might cause you to think twice before borrowing from your retirement fund. The hazards of 401(k) loans are many, and they are not to be taken lightly.

  • The Impact of Fees – At first glance 401(k) loans can seem fairly cost effective, but on closer examination you'll find that the various fees associated with your loan can greatly increase its total cost. Beyond the processing fees, there are annual maintenance charges to consider. These can be as much as 7.5% of the total loan amount. That can add significantly to the overall cost of your loan.
  • Hidden Costs – In addition to the fees you will have o pay on your loan, you should also consider the hidden cost of borrowing against your retirement fund. The money you withdraw, however temporarily, will no longer be working for you. It will be taken out of the market, and you won't be earning any dividends on that amount until it is fully repaid. You will also lose any tax deferments on the amount you withdraw.
  • The Effects of a Changing Market – The investment market is in a constant state of flux, and that can work against your long term interests when you borrow from your 401(k). If you take out your loan when the market is low, you may have to buy back in when the market is riding high. That can severely damage your retirement investments, and cost you much more than the value of the loan itself. Of course, the reverse is also true, but it's a dangerous gamble, particularly with something as important as your retirement savings.
  • Taxes – One of the benefits of a 401(k) is that taxes are deferred on your contributions. While the proceeds of a loan are not taxed when disbursed, the money you use to repay the loan will already have been subject to payroll taxes. Essentially, the interest on your loan will be taxed twice – once when you repay the loan and again when funds are withdrawn when you retire.
  • Defaulting On Your Loan – Defaulting on your loan can't hurt your credit score, as you are effectively borrowing money from yourself. However, it can play havoc with your finances. Should you fail to repay the loan in a timely manner, it will be treated as an early withdrawal and as such will be subject to penalties and taxes. That sudden expense can lead to even greater financial problems.

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The Dangers of Default

While we've touched briefly on the dangers of default, the subject deserves some closer attention. Defaulting on a 401(k) loan is a complicated business, and while it doesn't impact your personal credit score it can lead to some significant financial pitfalls. First of all, as long as you remain employed at the company that controls your 401(k) you can't slip into default. Regular payroll deductions will see to that. However, if you quit, or are fired, you will only have 60 days to repay the outstanding balance of your loan. If you fail to do so, your former employer will have to report to the IRS that you were unable to repay the loan. It will then be treated as a hardship distribution, and you will be required to pay taxes on the unpaid balance plus a 10% early withdrawal fee.

Another point to consider is the size of your unpaid loan. Remember, if you go into default the unpaid balance will be treated as taxable income, and depending on the amount owed it may push you into a higher tax bracket, effectively eliminating any expected deductions or credits, and leaving you with an unexpected financial liability.

Now, there are some 401(k) programs that will allow you to continue paying on your outstanding loan via a coupon book, even after termination. However, even this is problematical. While it can help you avoid going into default and facing a massive tax liability, it also keeps your 401(k) tied up with your former employer. Until you fully repay the loan, you will not be able to transfer your 401(k) to another company, or roll it over into an alternative retirement plan.

Other Options to Consider

Borrowing from your 401(k) may be easy, but it clearly has its drawbacks. Before you consider taking money out of your retirement savings, there may be some better alternatives. First, and foremost, whether you are facing a financial emergency or not, you should be actively working to build a healthy emergency fund. That means opening a high interest savings account that will put your money to work, and provide a financial safety net should an emergency arise. Simply deducting a little from your pay each week, and putting it into a high yield savings account, can make a big difference down the line.

You might also consider opening a Roth IRA. This can be an invaluable addition to your current retirement plan, allowing you to generate tax free income for your golden years. But an IRA can also help you in an emergency. Funds can be withdrawn at any time, without being subject to penalties or additional taxes. Of course, you will be reducing your retirement earnings, but you will be able to avoid some unnecessary loan fees and interest payments.

Admittedly, both of these options require a little forethought, and they can't be of much help in an emergency if you don't already have them in place. However, they're worth noting if only to give you an idea of what you can do to avoid emergency loans in the future. Once your current financial situation has stabilized, you should set your mind to building an emergency fund and/or augmenting your existing retirement plan with an IRA.

Financial emergencies can happen to anyone, and when they do your 410(k) may be your best option for an affordable short term loan. However, while borrowing against your retirement savings may be easy, it does have its disadvantages and these should not be taken lightly. If you must take out a 401(k) loan, borrow only the money you need and take all necessary steps to pay it back quickly and completely. One of the major benefits of these types of loans is that there are no penalties for early repayment, so take advantage of that feature and repay the loan is soon as possible. Remember, you are borrowing against your future, so you need to proceed with care.

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