Have you been contributing to a 401k loan and thinking of taking money out of it? You can apply for the loan, however, there are some 401k loan rules that apply. Read the full article to abreast yourself with what you need to know about those rules.
If you ever need money urgently to cover some unexpected expense, you may look at borrowing from your 401k as an option if seeking financial assistance is not possible elsewhere. Borrowing from a 401k loan is a low-interest mode to quickly get your hands on money; however, it is a big decision before your retirement. After all, you have worked hard and saved hard to contribute to your retirement fund.
If you plan to seek a 401k loan, you must know what a 401k loan is. A 401k loan allows you to borrow the money you have been saving up in your retirement account with the intent to pay yourself back. You pay interest on this loan similar to any other loan, and the interest payments go back into your account so that you will be paying interest to yourself.
People borrow from their 401k for various reasons, such as funding the purchase of a house or paying for a dependent’s college tuition. While some plans only allow participants to take a loan for specific approved reasons, in most cases, you will not need to declare why you are borrowing from your 401k.
While taking money out of your 401k plan is possible, it can impact your savings progress and long-term retirement goals, so it is essential to weigh the risks, costs, and benefits carefully. Hence, there are 401k loan rules you need to follow so that you avoid any mishaps, such as being taxed on the amount you borrow. Be sure that there are also possible drawbacks of 401k loans, like lagging behind potential investment growth, to consider before deciding to take out a 401k loan.
If you have a 401k retirement plan and need to borrow from this plan before you retire, you might have a few concerns and queries about 401k loan rules. This information will guide how it works and the rules and regulations. So, continue to read and make a wise decision!
Table of Contents
- 1 What is a 401k loan?
- 2 Why do people get 401k loans?
- 3 What’s new with 401k plans in 2022?
- 4 Will my employer know if i take a 401k loan?
- 5 If i pay off my 401k loan can i get another one?
- 6 How much can i borrow from my 401k?
- 7 Fidelity 401k loan
- 8 401k loan for down payment
- 9 401k loans: the pros and cons
- 10 Conclusion
What is a 401k loan?
A 401k loan allows you to borrow against your 401k retirement account, or let’s say, borrow money from yourself. It works similar to any other loan, so you have to pay interest on this loan. The interest you pay goes to your account. Hence your surcharge goes back to your account. While some 401k plans allow you to take out a loan, some plans do not allow it.
While you get a 401k plan, you must look at the documents to see whether your plan is allowed on your 401k account. If you are allowed to borrow, you’ll be required to pay your 401k loan back over a set period. A key difference with this type of loan is that you borrow money from yourself, paying yourself back with interest.
Why do people get 401k loans?
People get 401k loans for elective expenses such as entertainment or gifts, which is unhealthy. Whereas, in most cases, it would be better to leave your retirement savings fully invested and find another source of cash. On the flip side of what we have been discussing, borrowing from your 401k might be beneficial in the long term and could even help your overall finances.
For example, using a 401k loan to pay off high-interest debt, such as credit cards, could reduce the amount you pay in interest to lenders. Moreover, 401k loans do not require a credit check, and they do not show up as debt on your credit report, so people get these loans.
Nevertheless, the potentially positive way to use a 401k loan is to fund major home improvement projects. If the project increases the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings, you are good to go.
Here are some more uses for a 401k loan that people get a 401k loan for:
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Covering medical expenses
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
What’s new with 401k plans in 2022?
If you save for retirement through a 401k plan, you may have noticed a few changes in rules to it over the years, for example, automatic increases in your contributions and “catch-up” amount for the over-50 crowd.
A couple more tweaks, which were included in a 2019 retirement bill called the Secure Act, could also become more apparent shortly—both address workers’ interest in having guaranteed income in retirement. Here, we present a few things you may notice in 401k loan plans.
Contribution limit changes
You can contribute the maximum amount you can contribute to your 401k from year to year. For 2022, you can put up to $20,500 in a traditional 401k, up $1,000 from 2021. The 50-and-over crowd is allowed an extra $6,500 as a catch-up contribution, for a total of $27,000. Employer contributions do not count toward these limits.
However, the IRS does limit the combined contributions made by employers and employees. For 2022, that limit is $61,000, and it is $67,500 for participants age 50 or older, reflecting the catch-up amount allowed.
Small businesses might offer simple 401k plans but a contribution limit of $14,000 for 2022. The catch-up amount is $3,000. Solo 401k plans used by the self-employed with no employees except perhaps a spouse come with the same contribution limits as traditional 401k plans.
Estimate of guaranteed income
At some point in the coming months, you will probably see illustrations on your quarterly or annual statements showing an estimate of how much guaranteed lifetime income you could potentially get if your account balance were annuitized. The secure act incorporates this mandate for 401k plans and similar workplace plans.
Jason Berkowitz, chief legal and regulatory affairs officer for the insured retirement institute said, “The point is to help participants determine if they are on track to meet their retirement goals.” Under an interim rule issued by the U.S. The department of labor is now in effect, a final rule is expected relatively soon, and it could be different; you need two illustrations to be provided at least once a year. One would show estimated monthly income from a single life annuity and the other from a joint annuity with benefits for a surviving spouse.
The monthly amounts shown would be based on a worker’s current account balance and assume the payments were to start immediately and as if the person were age 67, or their actual age if older. Of course, if the person, let’s say, is 35, there are many years left to make contributions that will grow, which the illustration would not reflect. There has been some concern that the numbers they see could be deflating for savers with lower balances if based solely on what they have accumulated so far.
Annuities in your plan
Although companies have been permitted to include annuities in their 401k plans, the Secure Act aimed to eliminate companies’ fear of legal liability if the annuity provider were to fail or otherwise not meet its obligations. Now, insurance companies, asset managers, and employers are moving toward making these guaranteed lifetime income options more broadly available through 401k plans and similar workplace plans.
However, uptake by plan sponsors has been slow. Part of the problem is workers not understanding annuities and aversion to the idea of handing over their retirement savings in one lump sum. Moreover, workers take an interest in a guaranteed source of income in retirement, which also makes it challenging.
Annuities generally involve entering into a contract with a provider, typically an insurance company, whereby you hand over your money in exchange for the promise that you will receive regular payments across many years. Yet annuities can be tricky to understand and, depending on the type, pricier than other options for your money. However, annuities in your 401k may look different from those purchased outside the plan.
Will my employer know if i take a 401k loan?
You must know that your employer will know about any loan from their own sponsored plan. You may need to go through the human resources (HR) department to request the loan, and you would pay it back through payroll deduction, which they would also be aware of. There is no guarantee for your 401k loan approval, or your plan may not offer them at all. However, if you are concerned about the manager or executive finding out about the loan request, you can ask HR to keep your request confidential.
If i pay off my 401k loan can i get another one?
If you face tweaks on cash, you may consider borrowing from your 401k instead of taking a bank loan. Although not all employers allow 401k loans, you should check with your plan to see if it enables 401k loans. You can borrow 50% of your vested balance up to $50,000. Some 401k plans allow participants to borrow more than one loan as long as the total amount borrowed is within the IRS limit.
If you have an existing 401k loan, you can take another 401k loan at any time based on the highest outstanding balance in the previous 12 months. However, if you have exhausted your 401k loan limit, you must wait until the lapse of the 12-month rolling period to take a second loan.
401k loan limits
The IRS allows you to take a loan for half the vested value of your 401k account, or $50,000, whichever amount is smaller. Some plans allow you to take out multiple loans until you reach the maximum amount. There are 12 months of borrowing limitations; you can not take another loan even if you have paid the amount back early. For example, suppose the vested balance of your account is $200,000, and you take a $30,000 loan out in February. In that case, you will not have permission to take out more than $20,000 in additional funds again until the following February.
The borrower must pay back the loan at regular intervals over five years with interest. However, there is an exception to some circumstances, such as taking out a loan to purchase a home. In this scenario, you might get the privilege to have an extended payback time. However, if you leave the job or get a job termination, you will have to pay back the entire loan within 60 days.
401k loan advantages
If your credit score is low and you have trouble getting a low-interest rate loan, this type of credit may be a practical option. You are borrowing your own money, so you do not need approval from a lender, as with a conventional loan. Taking out a 401k loan usually does not impact your credit rating, so you will not have to worry about it taking another hit.
How much can i borrow from my 401k?
Plans can set their limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is more significant but not more than $50,000. For example, if you have $150,000 vested in your 401k account, then you would not be able to borrow the complete 50%, or $75,000, of your vested balance.
The most you could borrow in that scenario would be $50,000. On the other hand, if 50% of your vested account balance amounts to less than $10,000, your plan may include an exception and allow you to borrow up to $10,000. You may be able to take more than one loan from your 401k, but the total amount of your loan balance can not exceed these limits.
Fidelity 401k loan
No wonder 401k has some significant benefits when it comes to retirement plans. It allows you to access a 401k loan when no other option is available. With a 401k loan, you borrow money from your retirement savings account. Depending on your employer’s plan, you could take out as much as 50% of your savings, up to a maximum of $50,000, within 12 months.
Though the CARES Act permits plans to offer increased loan limits above the $50,000 standard limit, not all employers have adopted the new CARES Act provisions, so you must check with your employer to see what options you might have. To take a loan from your fidelity 401k plan, you need to submit a request for a 401k loan. You can log in to NetBenefits if you want to review your balances, available loan amounts, and other options.
401k loan for down payment
It is generally allowed to use your 401k loan for the down payment. If you have a 401k plan at work, you might have a convenient source for down payment funds. You are allowed to borrow money from this retirement account for a down payment.
You must be aware by now that you just have to pay back your loan with interest on time to avoid any penalties or taxes. Nevertheless, you must be cautious while making these decisions. It is imperative to weigh each potential risk while making this financial decision.
Buying a home is an exciting milestone, but it often requires a significant financial investment. While it is essential to calculate how much home you can afford and how your monthly mortgage payments will affect your budget, consider other costs.
A senior loan officer with “Chicago Financial Services” in Chicago, Heather McRae, said that a 401k loan has helped several clients gather the funds they need for down payments. According to McRae, it is a smart financial move for borrowers who know they can handle the payback schedule.
“If you don’t have the money for a down payment and you don’t have family members who are kind enough to give you the down payment, you’re kind of out of luck,” McRae said. “The 401k loan is often the best option for these buyers. If you haven’t saved the money for a down payment and you’ve fallen in love with a property, the 401k can make the purchase work.”
401k loans: the pros and cons
Borrowing money from a 401k is a common strategy to get through hard times. There are some perks to it, including that you do not need good credit to qualify for a 401k loan, and you pay interest to yourself instead of a creditor. Some Americans decide these benefits outweigh the considerable downsides, such as losing potential investment gains on the borrowed money.
While a 401k loan is a convenient way to face a financial tweak, we must bring it to your knowledge that every economic decision has its pros and cons. So is getting a loan from your 401k loan. Let’s walk you through them.
Following are the pros of 401k loans.
Compared with other forms of borrowing, 401k loans are a low-cost way to borrow money. Rather than paying a lender interest, you pay that interest to yourself. This could be a better option than using a credit card or taking out a loan that could have a higher interest rate. Interest rates may change, but you must be paying a rate comparable to the rate you would get if you took out a personal loan of a similar size through a traditional lender.
Since you are borrowing money from yourself, the process can be fast. You may be able to access your money within a week.
No loan application
401k loans do not require an application to borrow against your 401k, and you may not have to explain why you need the money. You still have to provide some information to your plan’s administrator, but it is not as complex a process as applying for a loan from a bank or credit union.
Credit scores and applications
As you are accessing your own saved money, your credit score, which is a number that lenders use to quantify your creditworthiness to potential lenders, does not affect your ability to withdraw the money. In addition, the borrowing of funds does not result in a hard inquiry, which occurs when a lender wants to look at your credit report so you will not experience a resulting dip in your credit score.
Your plan administrator does not report your repayments to the three major credit reporting agencies, Equifax, Experian, and TransUnion. Hence, if, for some reason, you do not repay all of the money, it will not impact your credit score and reports.
No taxes owed
The IRS (Internal Revenue Service) does not require you to pay income tax or a 10% early withdrawal penalty on the money you borrow, as long as you pay it back in time. This 401k loan rule is generally for five years; however, it may be as long as 15 years if you took out the money to purchase a home.
Whether related to insurance or financial leverage, every plan has cons, so is a 401k loan. You might want to be aware of them.
You may not have access to 401k loans
There are various plans for 401k loans, and some employers offer plans that do not allow workers to borrow from their retirement accounts, so a 401k loan might not even be an option for you. Hence, this could be a problem as not every plan allows borrowing from your 401k retirement plan. You should contact your plan administrator or look at its website to see whether your employer will enable loans from their retirement plan or not.
Missed investment growth
When you borrow money from your 401k, you cannot invest that money, which means you potentially lag on years of investment growth. There is no way to know in advance how much money your investments could earn, but it is imperative to understand that you could lose out on some investment returns.
On top of that, if you decide to reduce or stop contributions to your 401k account as you repay your loan, you could miss out on any returns on those contributions. When you stop contributions, you also lose out on any matching contributions from your employer.
If you leave your job before paying back the entire loan, any outstanding balance will come off as taxable distribution unless you pay it within a given period as required by your 401k loan sponsor.
401k plans are one the best and most feasible retirement plans available in the US. Most of the plans allow the holders to take out loans when needed; however, they will pay back this loan with interest, which goes back to their account. A 401k account is the biggest financial asset as it contains their savings for retirement. Therefore, some 401k loan rules apply to every borrower regardless of their status when people request a loan. These rules help define essential factors such as the maximum loan limits and the number of times a plan holder can apply for a loan.