When one contributes toward their employer-sponsored 401(k) plan, this money could grow into a huge nest egg when they retire. Technically, borrowing from one’s 401(k) plan isn’t a good idea, particularly when one doesn’t have any other savings toward retirement. However, when it comes to financial emergencies like personal bankruptcies, the 401(k) can provide loan terms that no bank will. Read on to know all about 401(k) loans in the country before making borrowing decisions about the same.
401(k) loans are not necessarily allowed
This might come as a surprise to many, but a 401(k) plan doesn’t necessarily allow borrowing. One needs to check with their investment company or 401(k) plan administrator to determine whether their plan allows them to borrow against their account balance. Also, while some companies don’t allow borrowing, there are some which allow for borrowing multiple loans.
Legal loan limits
401(k)s have a legal maximum loan amount, which is 50% of one’s vested account balance or $50,000, whichever is less. The vested account balance belongs to the individual. For instance, one might have to work for their employer for a specific amount of time before their contributions belong to the individual.
Payroll deductions repayment
Whatever one borrows from the 401(k) is paid back via automatic deductions from their paycheck. There are exceptions on the longest repayment term allowed, which is 5 years, and most repayment plans are structured as quarterly or monthly payments. Also, some 401(k) plans don’t allow contributions while the loan repayments are on.
Paying oneself interest
The rules of one’s 401(k) plan determine the interest rate, which is generally determined by a formula like “Prime + 1%.” Also, while one ends up paying the interest to themselves, borrowing from the 401(k) always hurts future retirement savings.
Old 401(k) plans don’t allow borrowing
If one’s 401(k) plan is with a company where they don’t work anymore, they cannot take a loan from it. For that, they need to transfer the balance from the former employer to a new 401(k) plan with the new employer and borrow from that if it is allowed. Also, if one transferred their old 401(k) to an IRA, they cannot borrow from IRAs.
Late repayment can possibly be costly
When one takes a 401(k) loan, they don’t pay taxes on the amount they get, but penalties and taxes might be levied if they don’t repay the loan on time. Also, if one leaves their employment while they have an outstanding 401(k) loan, the loan balance is considered a distribution unless they end up repaying it. According to the TCJA (2018 Tax Cuts and Jobs Act), the repayment deadline has been extended from 2 months to the day one’s federal IT returns are due. If the loan isn’t repaid, the outstanding loan balance could end up being considered as a distribution, which becomes taxable to the individual.
