How Does a 401k Loan Work?
When you borrow money from a 401k, investments in your 401k account are sold so cash can be distributed to you upfront. Typically, 401k loans are repaid over five years with equal payments. It’s possible to take longer to repay the loan if you borrowed the money to purchase a primary residence. Typically, these repayments are made through paycheck deductions, which are then redeposited in your 401k account.
The bright side is that the interest you’re paying gets added back to your 401k account. So, if you’re paying 5 percent interest, you’re essentially locking in a 5 percent rate of return on the borrowed money. However, you’re missing out on the returns you could have been earning had the money been invested.
What Happens If You Default On a 401k Loan
In a worst-case scenario, if you default on your 401k loan, the remaining balance is treated similarly to cashing out your 401k. Your plan might allow for a short grace period if you miss a payment — the IRS allows plans to provide that a loan doesn’t become a deemed distribution until the end of the quarter following the quarter in which the payment was missed.
If you leave your job, even if you’re let go through no fault of your own, you typically have 60 days to repay any remaining balance, or the remainder is treated as a distribution. Your plan might include language that allows your repayments to be suspended if you’re performing military service or if you’re taking a leave of absence for up to one year.
Like a 401k cash-out, the remaining balance is treated as a distribution from your account, making it subject to income taxes and potentially an early 401k withdrawal penalty — even though you might have already spent all the money. Even if you can afford to roll the money over within 60 days, the distribution isn’t eligible to be added back to another retirement plan.
Related: What is a Roth 401k?
401k Loan Alternatives
Before you take out a 401k loan, the IRS recommends you speak with a financial advisor who can help you determine the best option for you. Don’t settle for a 401k loan because it’s the easiest to obtain or even because it has the lowest interest rate, because the loan can negatively affect your account balance and reduce your retirement nest egg.
In addition, sometimes borrowing against your 401k might not be your cheapest loan option because of fees. For example, Vanguard charges a $40 online loan application fee or a $90 phone application fee plus a $25 maintenance fee for each year the loan is outstanding. MGO charges $100 upfront and $25 per year thereafter. Instead of being subject to fees like these, consider a personal loan or even home equity loan.
How to Get a 401k Loan
If your situation deems it necessary for you to borrow money from your retirement funds, there are a few steps you’ll need to take in order to get your money. Here’s how to get a 401k loan:
- Determine if your 401k plan permits loans. Just because the IRS regulations permit companies to offer 401k loans doesn’t mean that every 401k plan permits borrowing. Ask your plan sponsor if you don’t want to read the fine print.
- Calculate the maximum amount you can borrow. You don’t need a 401k loan calculator to determine the greatest amount you can borrow from your 401k; just use the smaller of $50,000, or the larger of 50 percent of your vested account balance or $10,000 — assuming your vested account balance is at least that amount.
- Obtain your spouse’s consent and use a paper application. Plans typically require spousal consent for loans exceeding $5,000 unless certain conditions are met. Even if it’s not required, it can be beneficial to discuss your big financial decisions with your spouse if you’re married.
- Fill out and submit the application. You can complete and submit your application by paper, over the phone or online, depending on the 401k rules of your particular plan. You’ll need to include which investments you want the money taken out of, how you want the money delivered and how long you want to take to repay the loan — if shorter than the maximum time allowed. Your spouse’s signature might need to be notarized.
Related: What is 401k Matching?
How to Decide If a 401K Loan Is Right for You
A 401k loan can provide you with necessary cash at a reasonable interest rate, in certain circumstances, regardless of your credit history. But remember that you are using your retirement savings: Even if you have the best intentions about repaying your 401k loan, you’re still tapping your nest egg. Keep in mind that you must pay the money back almost immediately if something goes wrong and you leave or lose your job. You could be hurting your golden years in addition to making yourself subject to extra taxes and penalties should you fail to pay the 401k loan back in time.