What is a 401 (k) loan?
A 401 (k) loan is money borrowed against a 401 (k) retirement savings plan. Borrowing from your own 401 (k) will not affect your credit and does not require a credit check, as the remaining assets in the account are used as collateral. For plans that allow loans, the loan must be repaid, with interest, within a set time frame.
Key takeaways
- Some employers allow participants to borrow against their 401 (k) account, but there are limits to the amount.
- A 401 (k) loan will not affect the borrower’s credit and no credit check is required.
- If you default on the loan, you will pay income taxes on the money withdrawn and may also be subject to an early withdrawal penalty.
- Depending on the plan, borrowers may not be able to make contributions if they have an outstanding loan.
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How the 401 (k) Loan Works
For critical short-term needs, borrowing from a 401 (k) account may be a better option than a hardship withdrawal, which is allowed under certain circumstances, or a high-interest bank loan. Any money borrowed from a 401 (k) account is exempt from tax, as long as you repay the loan on time. And you are paying the interest yourself, not a bank.
You do not need to claim a 401 (k) loan on your tax return. As long as the loan is paid on time, the only tax effect is the interest on certain plans. The term “interest” is a bit misleading because the funds go back to the participant’s account.
The borrower must use after-tax dollars to repay the loan, including interest. This means that the government cuts part of it twice: the income tax is paid again on the amount when the borrower draws on the retirement account. However, 401 (k) interest rates are generally relatively small, so double taxation has little impact. It is only significant when the amount borrowed is large and is repaid over several years.
The IRS allows loans of $ 50,000 or 50% of a vested balance, whichever is less. An exception is when the purchased balance is less than $ 10,000. In that case, you may be allowed to borrow up to $ 10,000, as long as the value of the vested account is at least $ 10,000. Each loan plan has its own limits and you don’t need to offer them, so check with your employer for details.
On March 27, 2020, former President Trump signed a $ 2 trillion coronavirus emergency aid package. He doubled the amount of 401 (k) money available as a loan to $ 100,000, waived 50% of the balance limit, and waived the early withdrawal penalty if he defaulted before age 59½.
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For example (under traditional non-coronavirus rules), if your grandfathered balance is $ 15,000, you can borrow $ 10,000 because 50% is only $ 7,500. However, if your balance is $ 120,000, the maximum you can borrow is $ 50,000. With the introduction of the CARES Act, you will only be able to borrow $ 100,000 of that $ 120,000 if the coronavirus pandemic affects your income. .
Default 401 (k) loan
Tax consequences are important for borrowers who default on a 401 (k) loan. Except in 2020 for those affected by COVID, those under age 59½ will be subject to a 10% early withdrawal penalty in addition to paying income taxes on the outstanding balance.
Let’s say you are under age 59½, defaulting on a loan with an outstanding balance of $ 10,000, and you have an effective tax rate of 15%. By the time you file your annual tax return, you’ll owe the government $ 1,000 for the early withdrawal penalty and another $ 1,500 in income taxes (which would be deferred until retirement). Within a year, that $ 10,000 dropped to $ 7,500.
401 (k) loan risks
Some plans do not allow participants to make contributions to the plan if they have an outstanding loan. If it takes five years to pay off the loan, you won’t save anything on your 401 (k). This also means that you will not take advantage of the tax benefits of making payments to your retirement account.
You will also lose any matching contributions that your employer can provide while repaying the loan.
401 (k) Loan vs. Retirement
It is important to determine if you can afford a 401 (k) loan before proceeding. Most planners recommend keeping your egg safe if you can no longer, for example, pay your rent or mortgage, utility bills, or food.
In short, if you need funds and are confident that you can repay the loan, minimal tax loans and the ability to top up your account with interest may be a viable option.
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