The 401(k) loan has grown to become one of the most popular loan sources. In fact, where lending is concerned, it’s not an exaggeration to say that 401(k) loans have become an American institution. According to the Employee Benefit Research Institute, 18% of 401(k) plan participants have outstanding loan balances.
How 401(k) Loans Work
A 401(k) loan is an asset-based loan you take against your employer-sponsored 401(k) plan. In a real way, you’re really borrowing money from yourself.
Under IRS regulations, you can borrow up to the lesser of:
- The greater of $10,000 or 50% of your vested account balance, or
In either case, the allowable percentages pertain to your vested balance and not your total balance. Any employer contributions that are not considered vested are not eligible to be borrowed through a 401(k) loan.
That means if you have $40,000 in your 401(k) plan and $10,000 is unvested employer contributions, the net value of your plan is $30,000. You can borrow 50% of the net value, which translates to $15,000.
When you take a 401(k) loan, it’s set up like any other type of loan. It’s for a specific amount of money and repayable over a definite term, usually not more than five years. Interest will be charged on the amount of the outstanding loan balance.
What makes 401(k) loans especially convenient is that repayment is payroll deducted. You don’t have to write a monthly check, and you don’t even have to set up an online automatic debit from your bank account. Your employer will simply add another line-item deduction from your regular paycheck. The deduction will continue until the loan is paid in full.
Just Because the IRS Permits 401(k) Loans Doesn’t Mean Your Employer Will
The IRS allows many provisions with 401(k) plans, but the employer doesn’t necessarily need to offer them. 401(k) loans fall into this category. So don’t assume an employer offers them just because they provide a 401(k) plan.
Other provisions include employer matching contributions and certain types of investments. While an employer can offer these provisions, they’re not required to do so. It doesn’t matter if they were offered by a previous employer. Each employer has the latitude to include or exclude certain provisions as they deem necessary.
401(k) Loan Costs
There are three costs associated with 401(k) loans:
- Administrative fees. There is usually some sort of fee charged by the plan administrator to create the loan. It might be something like $100. If the loan amount is $10,000, you are paying a 1% origination fee for the privilege of getting the loan. The fee is usually withdrawn from your plan balance. This causes a slight but permanent reduction in the plan’s value.
- Interest. 401(k) loans typically charge interest on the amount borrowed. The rate is usually one or two points above the prime rate, which is currently 4.75%. That would produce a rate of between 5.75% and 6.75%.That rate is lower than what you will pay for a loan from just about any other source. And on top of that, since the interest goes to your plan, you’re basically paying interest to yourself. That seems like a good deal, at least until you consider the next 401(k) loan cost…
- Opportunity cost. While the loan is outstanding and you’re making interest payments on the amount borrowed, you’re not receiving investment income on the unpaid balance. Even though the outstanding balance is receiving interest, you are the one paying it. You are still losing the “free” income from being invested.For that reason, a 401(k) loan is not a good deal from an investment standpoint.
The Advantages of 401(k) Loans
401(k) loans provide many advantages compared to other types of loans. That is a big part of the reason 401(k) loans are so popular.
These advantages include:
- No lender qualifying. With virtually every other type of loan, you must qualify based on your income, employment stability, credit history and credit score, and sometimes certain assets. With 401(k) loans, you qualify based just on the fact that you’re employed by the plan sponsor and you have sufficient equity in your plan to support the loan requested.
- No “outside” payment to make. As discussed earlier, repayment is handled strictly through payroll deduction. You don’t need to write a check and mail it to a third-party servicer or set up an automatic draft from your bank account.
- Paying interest to yourself. Also as noted earlier, you’re paying interest back into your own 401(k) plan. That means you’re not paying it to the lender, after which it’s gone forever.
- No taxes or early withdrawal penalties. If you were to liquidate the needed funds from an IRA or an old 401(k) plan, you would have to pay taxes on the amount withdrawn. As well, if you’re under 59½, you would have to pay a 10% early withdrawal penalty. But you can borrow money from a 401(k) plan without any tax consequences whatsoever.
- High loan amount. From how many other loan sources can you borrow up to $50,000 on little more than your signature?
- No complicated application process. Since you don’t have to be credit qualified, all you have to do is fill out an authorization form, and you get your loan. The proceeds can arrive in a matter of days.
The Disadvantages of 401(k) Loans
For all the shining positives, 401(k) loans also have certain disadvantages:
- Reducing your 401(k) contributions. Some of your contributions will be redirected into repaying the loan. This can reduce the accumulation of funds in the plan during the term of the loan.
- Reducing the invested portion of your plan. When money leaves the 401(k) plan as a loan to you, it’s withdrawn from investments. That means rather than earning potentially double-digit returns in exchange traded funds (ETFs) or mutual funds, it’s now earning single-digit interest paid by you.
Both these negatives will reduce the long-term value of your plan.
But there’s one 401(k) loan disadvantage you must be aware of…
Watch Out for the Sleeping Early Distribution Trap!
Should you leave your employer before the loan’s repaid, the entire outstanding balance will be due and payable. If not paid, it will be considered an early distribution from your plan. It will then be subject to ordinary income tax, as well as a 10% early withdrawal penalty if you’re under 59½ years old.
The employer will generally allow you up to 60 days to repay the loan balance. After that, it will be considered a distribution, and they will issue Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. You’ll be required to report the amount showing on the form on your income tax return.
A potential workaround to this dilemma is to roll over from your 401(k) a matching amount of the outstanding loan balance to an IRA or other tax-sheltered retirement plan within 60 days. Of course if you’re going to do that, you may as well repay the 401(k) plan and avoid the whole mess.
The Dos and Don’ts of 401(k) Loans
Obviously, 401(k) loans are an excellent credit source. But that’s precisely why you have to be careful using a 401(k) loan.
Do make sure your employment is stable. If you have any notion your job may end in the foreseeable future, it’s best not to take a 401(k) loan.
Do make sure you have funds to repay the loan — just in case. Even if you’re sure your job is safe, you should still have the ability to repay the loan if that situation changes for the worse.
Do pay off the loan in less than five years. Just because 401(k) loans run five years doesn’t mean you should make it take that long. The loan reduces both your contributions and your investment returns and is best repaid as soon as possible.
Don’t become a serial 401(k) loan borrower. Debt of all types is potentially addictive. 401(k) loans are no different. Precisely because they are so easy to get, you may be tempted to take another after the first is repaid. If you get into that habit, you may end up having a loan balance outstanding straight through to retirement.
Don’t be casual about taking a 401(k) loan. That means not borrowing for purposes like taking a vacation or some other purpose that’s temporary in nature. A 401(k) loan should never be viewed as a substitute for a credit card or a ready source of cash.
Don’t take a 401(k) loan if you already have a lot of debt. A sure sign of pending debt destruction is taking money wherever you can find it. If you already have substantial debt, you shouldn’t be tapping your 401(k) plan. If you can’t control spending without a 401(k) loan, taking one probably won’t help.
Final Thoughts on Borrowing From Your 401(k)
As you can see, there are a lot of benefits to borrowing from your 401(k) plan, certainly more than other loan types. But it’s not without its problems either, and even a landmine or two. Use 401(k) loans sparingly and only for the most important purposes.