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401(k) Loans- What Is It And How Does It Work

Getting a 401k loan is a good option for those who owe a serious amount of debt to the IRS or going through a foreclosure. Don’t be ignorant of the risks that come with taking out a 401k loan. In his article, we explain the basics of 401(k) loans by examples, consider the different options and review thr pros and cons of 401(k) loans
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What are 401(k) Loans?

In today’s world, economic hardship is on the rise. People have to find avenues to get the money they need fast to cover debt and other expenses. Whether it’s IRS tax debt or paying off a car loan, people discover that they have big bills that they can’t afford to pay because of not having an emergency fund.

In a situation like this, what would you do? Most people opt-in to take out a 401k loan. ¾ company 401k plans are set aside for those who need a 401k loan. Moreover, 30% of individuals take advantage of the 401k loan to cover debt and other expenses.

Getting a 401k loan is a good option for those who owe a serious amount of debt to the IRS or going through a foreclosure. Don’t be ignorant of the risks that come with taking out a 401k loan.

 How 401(k) Loans Work

Before we dive into the advantages and disadvantages of 401k loans, let observe how they work. Even though the rules and regulations of 401k plans may vary, they all share similar fundamentals.

  • Minimum withdrawals: 401k plans have a minimum amount a borrower can take out. It ranges from $500-$1000. In order to prevent people from short-circuiting their investment gains, lenders attempt to discourage borrowers from taking out small loans on a frequent basis.
  • Maximum loan amounts: Lenders allow people to borrow up to 50% of what is currently in their 401k. They don’t allow them to take more than $50,000. Also, be aware that you don’t have the opportunity to borrow what you invest in company matching funds. You can only borrow from what is personally deposited and what you invest periodically over time.
  • Payment terms: For the most part, a 401k loan has a 5-year payment term. The interest rates are at prime rates with an additional 1%. If you decide to borrow to buy a home, longer payment terms are available.
  • Fees to process your loan: In order to process your loan, lenders require a fee upfront. The amount can range from $50-$100.

From my perspective, look into the provisions and stipulations before taking out a 401k loan with the company you are in association with.

How Much Can You Borrow?

Trying to determine the amount you can borrow from your 401k can be difficult to determine. Here’s a brief summary.

If you didn’t borrow against your 401k in the past 12 months, you can borrow the lesser of the following:

  • $50,000
  • 50% of the amount you have put towards your 401k balance. If the amount is less than $10,000, you have the option to borrow up to $10,000. You just can’t borrow more than your total account balance.

This may seem like a cake walk, but it’s not. Here’s why…

If you withdrew from your 401k within the past 12 months, the amount you can borrow decreases by the largest balance you had within that period.

Come on and let’s look at some examples of this:

  • Example 1: Baruch has $30,000 in his 401k. He hasn’t had a 401k loan balance within the past 12 months. Baruch has the option to borrow up to $15,000.
  • Example 2: Fred has $25,000 in his 401k. Fred also had a 401k loan balance of $5,000 within the past 12 months. He can borrow up to $7,500.
  • Example 3: Rivi has $250,000 in her 401k. She hasn’t had a 401k loan balance within the past 12 months. Rivi has the option to borrow up to $50,000.
  • Example 4: John has $17,000 in her 401k. In addition, he hasn’t had a 401k within the past 12 months. Moreover, he can borrow up to $10,000.

401(k) Loan Taxes

Now check this out. When you initially take out a 401k loan, you don’t pay taxes on the amount you receive. The not so good part about this is if you don’t repay on time, taxes and penalties are due. If you transition out of your employment with having a 401k loan, the people behind the system consider it a distribution at that moment. This won’t be so if you repay it all back within 60 days.

If you don’t repay the loan in accordance with the term given, anything else remaining is a distribution.

As a result, this becomes your taxable income. If you’re under the age 59 ½, the big wigs will apply a 10% early penalty tax. 10% percent of loans transition to default because of job changes. To make matters worse, there are not enough resources to satisfy these loans.

What Happens If You Default on the Loan?

Defaulting on a loan happens when you don’t follow the terms of the loan. This means that you didn’t make your payments on time, or if you didn’t repay back the loan within 60 days of leaving the company.

As a result, the remaining balance counts as a distribution from your 401k. Here are the consequences that one would face:

  • If you’re at the age of 59 ½ or meet other criteria, that amount of money is taxed with a 10% penalty.
  • The amount that’s I default doesn’t qualify to roll over into an IRA or some other retirement plan. As a result, there’s no way to avoid the taxes and penalty.

The cool thing is that defaults aren’t reported to the credit bureaus. This means that it doesn’t have an impact on your credit score, like other loans approvals. On the hand, if you’re applying for a mortgage or personal loan, lenders have the right to ask you regarding any 401k loan defaults. They will consider this while making a decision.

How Do You Apply for a 401k Loan?

If you got money in your 401k, the loan application process is a breeze.

Other than knowing the restrictions (see above), all you have to do is request a loan. You can apply online or through your human resources department if necessary.

Don’t worry; there are no credit checks for those who apply for a 401k loan. As a result, it’s easier to get this type of loan. Another advantage is that these loans have to be available to all employees. This means that you qualify for approval no matter the position you have with the company you work for.

Here's a summary of the main pros & cons (click to see explanation or scroll down):

Pros Cons
A Small Amount of Paperwork Only Needed Defaults, Penalties, and Taxes
Paying Yourself Interest Fees
Easy Repayment Money Taxed Twice
Lost Retirement Gains
Transitioning to Another Job or Being Fired

Pros of 401(k) Loan

I’m not a big fan of 401k loans because they short-circuit the gains that are long-term that you could have for retirement. On top of that, they carry a big risk. Even though this is true, there are some circumstances where I may take out one.

Here’s a great example:

If you have to pay a large sum of money to the IRS, getting a 401k loan is a better option than getting in trouble with the IRS.

I mean… you don’t want to go to prison, right? Being at risk of foreclosure or losing your vehicle to the repo-man are other reason why you may want to consider a 401k loan. Be aware that there are risks involved.

Let’s take a look at some of the reasons why getting a 401k loan can be a good thing.

  • A small amount of paperwork only needed: Normally, very little paperwork goes into applying for a 401k loan no matter if you need it or not. For most people, it’s as easy as applying online or making a quick phone call. The only time they may inquire more information is if you’re applying for a mortgage.
  • Paying yourself interest: When you apply for a loan or credit card, you have to pay the bank interest. Regarding a 401k loan, you pay yourself interest. How sweet is that!
  • Easy repayment: Most of the time, the 401k loan repayment is taken out your check directly. This is super beneficial because it makes paying back your loan a cinch. Since it comes out of your paycheck automatically, you don’t feel the loss of losing money.

Even though I’m not fond of 401k loans, they can be a good alternative to standard loans if you find yourself in a dire financial situation. As I state, there are advantages to 401k loans, but there are risk factors as well, which we are about to dive into next.

Cons of 401(k) Loan

There are a lot of risks that accompany 401k loans. If you aren’t wise, you may suffer serious consequences.

  • Defaults, penalties, and taxes: If you default in your loan for whatever reason, you will have to pay taxes on it at the normal rate. On top of that, you have to pay a 10% early withdrawal penalty. This means that you may have to pay a big tax payment during tax season. Moreover, most people aren’t prepared for it because people typically spend the money beforehand.
  • Fees: If you’re not observant, you could be losing money to various fees. You may have to pay loan origination fees as well as an annual maintenance fee. For instance, if you got a $1000l loan with a $75 origination fee and a $25 maintenance fee on a 5-year loan, you’ll have to pay $200 in fees or 20%. That’s a lot of money to dish out all at once. Always be aware of the fees that accompany your 401k loan plan.
  • Money taxed twice: As you begin to pay back your 401k loan, you’re using post-tax funds to do so. Because the money is going right back into a pre-tax account, it will be taxed again when a distribution is taken during retirement. That’s what you call double taxation!
  • Lost retirement gains: If you begin to take out money out of your 401k, you are also losing any gains that you would have had if you didn’t. The price you pay is even greater if withdraw while the market is down and it isn’t returned to your account until the market rises again. So here’s the point: you miss out on any gains your money had the potential of making.
  • Transitioning to another job or being fired means loan comes due: If you transition to another job or got let go, your 401k loan becomes due immediately. The good thing about it is that there’s usually a 60-90 grace period. If you don’t pay back the loan on time, you’ll have to pay a 10% penalty as well as your normal tax rate equivalent to a normal default. Moreover, it means you could see 35%-40% in taxes and penalties. When tax season rolls around, you have to pay a lot of taxes at a time when you don’t want to lose more money!

The reality is this. There are more cons regarding 401k loans than there are pros. There are many risks that accompany the fees charged, penalties when you change or lose your job, and losing investment gains. As you can see, this is something very serious to think about.