How 401k Loans Work

 

A 401(k) loan is a way to access cash from your retirement savings temporarily. Here’s how it works:

1. Eligibility and Borrowing Limits:

   • Depending on your retirement plan, you can legally borrow up to 50% of your 401(k) savings or a maximum of $50,000 within a 12-month period.
   • If your vested account balance is less than $10,000, you can still borrow up to $10,000.
   • No credit check or dealing with lenders is required; you can access these funds directly from your 401(k).

2. Interest and Repayment:

   • The interest rate for a 401(k) loan is usually one or two percentage points above the prime rate.
   • You’ll need to repay the borrowed amount, along with interest, within five years of taking out the loan.
   • Unlike a 401(k) withdrawal, a loan doesn’t trigger taxes or penalties. The repayments (including interest) go back into your retirement plan.

3. Loan Process:

   • Your 401(k) plan allows you to borrow a portion of the money in your account on a tax-free basis.
   • You can usually take out up to $50,000 or 50% of the total, whichever is less.
   • Some plans allow more than one loan at a time, as long as the total doesn’t exceed the plan’s maximum.
   • Most loans must be paid back within five years, but you can repay it faster without penalties.
   • Repayments are typically made through payroll deductions using after-tax dollars.

4. Pros and Cons:

   • Advantages:
     • Convenience: Quick access to cash for unexpected expenses.
     • Interest Paid Back: The interest paid on the loan goes back into your 401(k).
   • Disadvantage:
     • Job Loss Impact: If you lose your job or change jobs before fully repaying the loan, the full amount must be repaid within a specified time¹²³.

Remember that while a 401(k) loan can be helpful in certain situations, it’s essential to weigh the pros and cons carefully and consider alternatives before borrowing from your retirement savings.