About 50 million working Americans contribute to a 401(k) plan. According to a study cited by Time, one in four will tap their 401(k) or similar retirement plans before retirement. In 2010 about $70 billion was taken from retirement accounts, according to the study.
Given that, we thought it would be helpful to put together this guide to borrowing from your 401(k).
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With a 401(k) loan, you borrow money from your own retirement account. As with any loan, you’ll pay interest set by your employer. Unlike a traditional loan, the interest goes back into your 401(k) account. Yes, that means you’re paying interest to yourself.
Some advantages of taking out a 401(k) loan are that there is no credit check and it is a relatively fast procedure. The administration fee you pay for the loan also tends to be modest.
There is one big disadvantage to borrowing from your retirement account. While the money is out of your account, it’s not being invested in the stock market. If the market is on the rise, you’ll miss the gains you otherwise would have received.
Many plans offer loans but not all. So be sure to check with your plan administrator to find out if loans are offered and what the stipulations are. This is usually as simple as calling the number on your statement or checking the plan’s website.
Some plans offer hardship withdrawals. A hardship withdrawal is different than a 401(k) loan because you can’t pay it back and you will pay regular taxes and a 10 percent penalty on the withdrawal if you are younger than 59 1/2. You also have to qualify for hardship conditions: hefty medical expenses; purchasing, repairing or preventing eviction from a home; or educational or funeral expenses. With most 401(k) loans, you don’t have to qualify for hardship conditions.
How Much Can You Borrow?
It depends. Usually, you can borrow 50 percent of the vested value of your 401(k) account, up to $50,000. There is an exception. If your account balance is less than $20,000, then you can borrow up to $10,000, even if this is your entire balance. For those who have a balance of more than $20,000, you will be limited to withdrawing half of your vested amount or $50,000, whichever is less. Many plans also set a minimum balance amount, usually $1,000, and married participants may need their spouse’s consent to take out the loan.
How Do You Repay the Loan?
One nice thing about a 401(k) loan is that you are paying interest to yourself. The interest rate is usually calculated by adding one or two points to the prime rate. You can find the current prime rate by checking the Wall Street Journal prime rate. This rate is derived by surveying large banks and publishing a consensus prime rate. As of March 2013, the prime rate is 3.25 percent.
Loan payments need to be made at least quarterly but are usually taken out of regular payroll deductions. This principal and interest is put back into your plan and reinvested.
You usually have five years to repay the balance of your loan. If you used the loan to purchase a home, you may have a longer repayment period.
There are also rare repayment exceptions for employees who take a leave of absence or who are on military leave. During a leave of absence, an employee may be able to suspend payments, although he or she will have to make extra payments to make up for the deficit once payments restart. If the employee is on military leave, the payments can be suspended and the years of leave will be added to the five year repayment time.
How Much Will it Cost?
To calculate your payment, you can use any loan amortization calculator, such as the one from Bankrate.com or the one from About.com. Plug in your loan amount, the amount of interest you will be paying, and the number of years you will be repaying the loan. For instance, a $10,000 loan, at 3.25 percent, over five years will be $180.80 a month. If you are paid weekly or bi-weekly you can divide that amount by the appropriate number of monthly pay periods.
Some plans do not allow you to make new contributions to your 401(k) plan until your loan is repaid. Rules and regulations vary by plan, so it is best to check with your plan administrator to find out if you can contribute to your plan during the repayment period. If it is allowed and you can afford it, continuing to contribute to your plan would help eliminate some of the opportunity cost of a 401(k) loan.
What if You Change Jobs?
It is a good idea to consider your job stability when deciding to take out a 401(k) loan. When you leave the employer who sponsors your plan, you will still need to repay the money.
Some plans will offer coupon books that you can use to continue making monthly payments into the plan, until your loan is repaid. Other plans give you 60 days to repay the loan in full. If you can’t repay the loan within the 60 days, the loan will be in default. When the loan is in default, the IRS treats it as a regular distribution and you are subject to regular income taxes and a 10 percent penalty (if you are younger than 59 1/2).
There is a lot to consider when taking out a 401(k) loan. Specific regulations differ from plan to plan. I have taken out one hardship withdrawal and one 401(k) loan during my working career. Both of these were as easy as a quick phone call to my plan administrator and a small amount of paperwork. Be sure to check with your plan administrator for the specifics of your particular 401(k) plan.
Do you have more questions about taking out a loan from your 401(k)? Ask in the comments section!