Many employers provide 401k retirement plans to their employees, and some will even match contributions to a 401k plan up to a certain percentage or dollar amount. Contributes made into a 401k plan are made before taxes, and the money is taken directly from your paycheck and deposited into the retirement plan automatically.
While the primary purpose of a 401k plan is to save for retirement, it is possible to borrow money from your 401k. As simple as it sounds, it doesn’t mean that borrowing against your 401k is always the best option. A decent emergency fund should be set up in place before any investing takes place. If you’re in a bind and have no other choice, here’s what you should know before you take out a 401k loan:
Borrowing Rules of 401k Plans
Your retirement plan is not like a savings account that you can just dip in whenever you want to take out the money you’ve saved. The maximum amount allowed for borrowing is 50% of the fund or up to $50,000 – whichever is less. So if you have $60,000 you can only borrow a maximum of $30,000. One of the primary benefits of borrowing from your 401k is that you don’t need to go through a credit check to get a loan, the way you would if you were borrowing from a bank. Another positive compared to taking out a traditional loan is that processing fees are minimal. Since a bank or financial institution is not involved and only your employer, the transaction costs should be next to nil.
When you take a loan from your 401k, you’ll pay it back with interest. Normally, the interest rate is the prime rate plus 1% but it is set by your employer. Repayment terms are also determined by the employer, but most allow up to 10 years to pay back a 401k loan. If the money is being borrowed for a down payment on a home, you may be given a repayment term up to 30 years.
Paying Back 401k Loans
Your loan repayments are deducted directly from your paycheck from your after-tax earnings. If you don’t pay the loan off before you reach the age of 59 and a half, you will receive an IRS penalty of 10%, as well as income tax on the entire amount of money borrowed (not just how much you still owe).
Changing Jobs or Getting Laid Off
If you decide to change jobs, quit your job or get laid off – you have between 30 and 60 days to pay off your 401k loan in full. You don’t want to take a loan from your 401k if you think there is a chance of changing jobs or getting laid off! If you had the money to pay it back in full all at once – then you wouldn’t have needed to borrow from it in the first place.
Reducing Your Retirement
Most financial experts will advise you not to borrow from your 401k plan if you have any other options available to you. When you borrow money from your 401k, you lose out on the earnings your retirement account would have made on that money. When the loan is paid back, your 401k account will still be smaller than it would have been if you hadn’t taken the loan – since you missed out on some of the earnings your account would have made. It may be a small amount difference at the time, but that small amount would actually grow until you reach retirement. So, if you’re $900 short after paying back your loan in money you would have had if you didn’t take a 401k loan, over the course of 8 years with a 401k plan earning about 9%, it would double. So if you have 16 years until you retire, you would actually have $1,800 less in your account at retirement time. The further away from retirement you are, the more that loan is going to “cost” you in terms of what it could have earned if you didn’t borrow the money.