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How to Take a Loan from Your 401k

loanYou have this 401k account that you’ve been contributing to over the years, and now you’ve found yourself in need of a bit of extra cash. Maybe you need to cover the cost of a new furnace, or possibly you have some extra medical bills that need attention, and you don’t have the extra cash to cover. Whatever the reason, a loan from your 401k might be just the ticket.

A 401k (or other employer-based plan like a 403b, 457, etc.) is unique from an IRA in that you are allowed to borrow against the account. An IRA can never be borrowed against, any withdrawals are immediately taxable.

Before we go into the specifics of taking a loan from your 401k, since I’m a financial planner I have to put a word of warning out: Borrowing from your 401k should be considered a “last resort” option, when you’ve exhausted all other options. This is because when you take a loan from your 401k you are side-tracking your retirement savings due to the fact that you have to divert income toward paying back the loan. The end result is that instead of growing steadily via your payroll deductions, after the loan is paid back you’ll be pretty much where you were before.

The good news is that taking a loan from your 401k may be one of the most cost-effective loans available, since you’re effectively borrowing from yourself. The downside mentioned above should be factored into the cost, but if you’re really up against the wall and have no other options, you can do much worse than a loan from your 401k.

Taking a loan from your 401k

All 401k (and other qualified retirement plans) have the option of allowing participants to take a loan against the account. (Some administrators restrict the option, so you’ll want to check with the rules of your plan.) The way this works is that you determine the amount you want to borrow (there are limits, see below) and then complete the paperwork to arrange the loan.

At the time of the loan, you also must make arrangements for the payback. Typically this is handled the same way as your normal contributions to the account, via payroll deduction. There will be a particular interest rate applied to the loan, often referred to as tied to a rate index, such as “Prime plus 2%”.

Then your loan repayment period of time is set as well. The longest you can spread out your repayments is five years from the loan origination. You could choose a shorter period of time if you like.

In addition, if you are unable to complete the loan repayment schedule as planned, you may have to recognize the loan withdrawal (or remaining balance) as a distribution of taxable income. Plus, if you’re under age 59 1/2 this could also require a 10% penalty for early withdrawal, unless you meet one of the other early withdrawal criteria.

Loan repayment may be suspended for up to one year in the event of the employee’s taking a leave of absence, but the original loan repayment schedule will remain intact.

If you leave your employer, typically you are required to either pay off the loan completely (immediately). If you are unable to do so, you will have to recognize the outstanding balance as a distribution as described above.

What are the limits?

I mentioned earlier that there are limits to the amount that you can borrow in a loan from your 401k. The maximum amount that can be borrowed at any one time is 50% of your vested account balance, or $50,000. This means that if your 401k balance is $200,000, the most you can borrow at any one time is $50,000. On the other hand, if your account balance is $50,000, you can only borrow $25,000 (50%).

If your 401k balance is less than $20,000, you are permitted to take up to $10,000 or 100% of your vested 401k balance, whichever is less. So if your vested account balance is $7,500, the most you could borrow is 100%, $7,500. If the account balance is $18,000, the most you could borrow would be $10,000.

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