Early withdrawals made from a 401k plan are subject to a 10% penalty plus income taxes on the amount drawn. If your plan provider enables loans as an option for participants, a 401k loan could be the better alternative to an early withdrawal if you’re in urgent need of emergency funds.
What is a 401k loan?
A 401k loan lets you borrow money from your 401k plan. You’re allowed to borrow up to 50% of your account’s value up to a maximum of $50,000. You must pay back the loan, plus interest (the interest payments go back into your 401k), in 5 years. If you use the money to purchase a primary residence, you may be given up to 15 years to pay back the money.
A 401k loan isn’t technically a loan since there is no lender. Loans from your 401k do not require a credit check, and failed or missed payments do not affect your credit score. Technically, you’re just given access to your 401k funds, with the requirement that you must pay it back.
What are the interest rates of a 401k loan?
The interest rates are set by your plan provider and is usually prime rate plus one or two percent. With a 401k loan, all interest payments go straight back to your account, so technically you’re paying interest to yourself.
Also read: Fees, Interest Rates, Taxes of a 401k Loan
How long do I have to pay back the money?
You’re given 5 years to pay back the amount you borrowed. If you use the money to purchase a primary residence, you may be given up to 15 years to return the money (repayment period depending on the 401k plan provider).
How much can I borrow?
The IRS lets you borrow up to 50% of your 401k plan’s value, up to a maximum of $50,000.
For example…
- If you have $50,000 in your 401k, you could borrow up to $25,000.
- If you have $100,000 in your 401k, you could borrow up to $50,000.
- If you have $500,000 in your 401k, you still could only borrow up to $50,000.
Funds must be vested in order to take out a loan
With a 401k, your employee contributions are always 100% vested. However, employer contributions to your account could have a vesting period that hasn’t been met yet. Some companies require at least one or two years of service before employer matched contributions are 100% vested.
How long does it take to receive my loan?
One of the best parts of a 401k loan is that there’s no lengthy application process. If your plan provider has a website you can log into, you could normally request the loan with just a few clicks online. In most cases, you should be able to have access to your funds in just a few business days.
8 Advantages of a 401k loan
Despite the fact that you’re depleting your retirement account of funds that would otherwise be invested, there are several advantages to a 401k loan.
1. There are no credit checks
If you have low credit, a 401k loan could be a saving grace. Where else can you get instant approval for a loan up to $50,000 without heavy credit checks? Because you’re technically borrowing money from your own account, there is no lender, and no credit check required for a 401k loan.
2. A 401k loan is fast
Applying for a loan with financial institutions usually involves a lengthy application process. A 401k loan has no application process; nobody needs to approve you for a loan. As long as your plan provider allows participants to take out a loan, the process is almost instant and takes just a few business days for you to get access to your money.
3. You can borrow a sizeable amount
The maximum amount you could borrow from your 401k is 50% of your plan’s value, up to $50,000. In order to borrow the maximum amount of $50,000, your account would need to have at least $100,000 in funds.
4. There are no penalties or taxes
Money taken out of your 401k through a loan is not taxed or penalized. There is no 10% early distribution penalty, like you would get for making an early withdrawal before the age of 59½.
5. Interest rates are lower than personal loans or credit cards
The interest rate on a 401k loan is usually Prime Rate plus one or two percent.
6. Interest rates get paid back to you
Rather than interest rates being paid to a bank or creditor, it goes straight back into your 401k.
7. Long repayment period
You have 5 years to pay back the money, which is longer than what most personal loan providers will give you. If you use the money to purchase a primary residence, you can extend your repayment deadline up to 15 years.
8. Missed payments do not affect your credit score
If you fail to repay the loan, a 401k plan provider doesn’t report your missed payment to credit reporting agencies. You’ll have to pay penalties assessed by the IRS, but your credit score doesn’t get affected.
6 Disadvantages of a 401k loan
Here are the disadvantages of taking out a loan from your 401k plan.
1. Loss of potential gains
The biggest downside of a 401k loan is that you’re withdrawing money that would otherwise be invested and earning you compound interest.
2. Not available with all plan providers
A 401k is only available if your plan provider allows the option to borrow from your account. Many plan providers do not offer the option to take out a loan.
3. Quitting or being fired could result in faster repayment required
If you end up leaving your employer, or get terminated, your original 5 year repayment period disappears. Instead, you’ll have to repay the loan by the federal tax deadline, the following year after you took the loan.
4. You may have to pay fees
Some plan providers may charge an origination fee along with a maintenance fee for offering the loan option.
5. You may not be able to contribute until you repay the loan
Some plan providers may not let you make any further contributions to your 401k until your loan is repaid. If your company offers employer matched contributions, you’ll miss out on those as well until you repay the money.
6. You have to pay taxes twice
There is no tax for taking out a 401k loan. However, you must repay the loan with after-tax income. If you borrowed money from your traditional 401k, you’ll have to pay taxes again when you make withdrawals in retirement.
What happens if I don’t pay back the loan?
You’re given 5 years to repay the 401k loan. If you miss the repayment deadline, your loan will be treated as an early distribution from your account. You’ll be hit with a 10% penalty, plus income taxes on the amount withdrawn.
For example, if you borrowed the maximum amount of $50,000, you’ll have to pay $5,000 to the IRS in early distribution penalties, and also have to pay income taxes on the $50,000 that’s now being counted as a withdrawal.
What happens if I leave my employer?
If you leave your job, or get terminated, the 5 year repayment period disappears and you’ll have to repay the loan by the federal tax filing deadline the year after you took out the loan.
For example, if you took out a 401k loan in March of 2022, you’ll have until the federal tax filing deadline in 2023 (which is April 18, 2023) to repay the loan.
Loan vs early withdrawal
As long as you have plans to repay the money, a 401k loan is usually the better option than making an early withdrawal from your 401k.
An early distribution is more expensive. You’ll have to pay 10% in penalties, plus income taxes on the amount withdrawn.
A 401k loan has no penalties or income taxes as long as you repay the money before the 5-year deadline (15 years if you use it to purchase a primary residence). Interest rate is Primate Rate plus one or two percent.
Also read: Roth 401k Withdrawal Rules
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