How Do 401K Loans Work?

by David Rodeck, Demand Media
    The IRS places a $50,000 limit on 401(k) loans.

    The IRS places a $50,000 limit on 401(k) loans.

    While your 401(k) is supposed to be used for retirement, it does give you a few options for taking out your money earlier. One way is through a plan loan. This is an effective way to borrow money because you are borrowing from yourself and won't owe interest to a creditor. Just be careful when repaying, as the IRS penalizes forfeited 401(k) loans.

    Getting a Loan

    Not all 401(k)s allow plan loans. When your employer set up your plan, he decided whether it would offer this feature, If your plan doesn't offer loans, you won't be able to borrow your 401(k) savings. If your plan does offer loans, you're guaranteed to get one. You can borrow your 401(k) funds for any reason, and you don't need to get your employer's approval first. You also don't need to pass a credit check to take out a 401(k).

    Loan Limits

    The IRS limits the amount you can borrow from your 401(k). Your limit depends on the amount of money you have in your account. If you have less than $100,000, you can borrow no more than half your account balance. If you have over $100,000, you can borrow a maximum of $50,000. This limit applies to the combination of all your 401(k) loans. No matter what, you won't be able to borrow more than $50,000 at one time from your 401(k).

    Repayment

    When you take out a loan from your 401(k), you need to pay it back. Most loans need to be repaid within five years. The only exception is if you borrow money to buy your primary residence. In this case, you can take up to 15 years to repay your loan. You also need to pay interest on top of the loan balance. Your interest rate depends on your plan. Generally, it is 1 to 2 percent over the primary rate.

    Missed Payment

    If you don't pay your loan back on time, the IRS counts the loan as a withdrawal. You will then owe income tax on whatever you haven't paid back into your account. If you are younger than 59 1/2, you will also owe an extra 10- percent early-withdrawal penalty and be frozen out of your plan for the next six months. This means you won't be able to add money into your 401(k) or receive matching contributions from your employer.

    About the Author

    David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.

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