A 401(k) loan is different from a distribution because a loan means you intend to pay the money back to your account. In essence, you borrow from yourself. Here’s how it works, subject to additional restrictions and criteria possibly added by your employer:
- You request a loan from your plan.
- Typically, the loan amount cannot exceed the lesser of either 50 percent of your vested balance or $50,000.
- You must pay back the loan in 5 years or less (unless you are using the loan to buy a house, in which case the term of the loan can be much longer).
- You must pay interest.
You: Doesn’t seem so bad—I’m paying the interest to myself, right?
So smooth. A 401(k) loan isn’t terrible, but it isn’t desirable either. Most often, the loan is preferable to an outright pre-retirement distribution. You don’t pay taxes and penalties and, yes, you pay interest to yourself. But there are negative repercussions to consider before borrowing from your 401(k) plan:
- During the time your money is on loan, it doesn’t grow. The amount borrowed is temporarily gone, and since it doesn’t exist it can’t grow.
- If you do not pay back your loan, it becomes a distribution subject to taxes and penalties.
- Your loan repayments are made with after-tax money. In other words, you use money from your net pay to repay the loan. To make a loan payment of $100 if you are in the 25 percent tax bracket, you must earn $133 of gross income. You pay $33 in income tax and the rest can be applied to the loan. Then, when you receive money from your 401(k) plan during retirement, you pay tax on that $100 again! That’s because 401(k) contributions are made with pre-tax dollars; loan repayments are made with post-tax dollars.
- If you terminate employment with the company you work for, the entire amount of the loan is due, usually within 60 days of your last day of work. This is typically true regardless of whether you quit, are fired, or are the victim of a major layoff. Any amount you are unable to pay becomes a distribution, likely subject to taxes and penalties.
Given the length of time people stay at their jobs, don’t expect much time to pay back a loan. A 401(k) loan is a bit like playing with fire. Consider alternative sources of money and the necessity of the expense before tapping your 401(k) plan. A 401(k) plan is a retirement plan and you should use it that way.
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Have you ever taken a 401(k) loan? How did it work out for you?