401K Loans Explained

If you need extra money in a financial emergency, and have a 401(k) plan through your employer, you may be able to use a 401(k) loan rather than applying for a traditional loan. A 401(k) loan simply means you borrow money from your own 401(k) plan. If you pay your loan back promptly, a 401(k) loan can be better than a traditional loan – but if you do not, the penalties can severely impact your retirement savings.

 How 401(k) Loans Work

If you take out a loan against your 401(k) plan, you will not have to write checks to make your repayments. Instead, your employer takes an additional deduction out of each of your paychecks until the loan has been repaid. You will have to pay interest, just like with a traditional loan – but this interest is also deposited into your 401(k) plan, to make up for the interest your money would have gathered if you had not taken out the loan.

The Advantages of a 401(k) Loan

In a traditional loan, you are borrowing a sum of money from a bank – but with a 401(k) loan, since the money in a 401(k) account is your own money, you are borrowing from yourself. This means you will not have to undergo a credit check or fill out a lengthy application form – some 401(k) loans require nothing more than a phone call to your employer. 

You also will have a lower interest rate than a traditional loan – usually the interest rates on a 401(k) loan are only one or two percentage points above the prime rate. Also, the interest on the loan goes back into your 401(k) plan, which you will be able to collect when you retire. You also will not have to pay taxes on the interest, or on the loan itself.

Potential 401(k) Loan Problems

Even though the money in a 401(k) plan is your money, you cannot borrow all of it. Most plans will only allow you to withdraw 50% of the funds in your account, and some employers place limits on what you may use the loan for. Other employers may temporarily withhold their own payments into your 401(k) account until you repay your loan.

Also, if you lose your job before the five-year repayment period is up, your employer may report any unpaid portion of your loan as “additional income” – and you will have to pay tax on that income. Or, your employer may report the unpaid portion as a withdrawal from your 401(k) plan, and you will have to pay an additional 10% early withdrawal fee on that portion.

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