How Do 401(k) Loans Work?
Understanding how 401(k) loans work can help you decide if taking one out in times of need is the best option.
When faced with a financial emergency, it may be tempting to pull money out of your 401(k). While not always advisable, it can be an excellent source of capital to get out of a tough spot. IRS rules surrounding retirement accounts make it difficult to access the funds in a 401(k). However, 401(k) loans are tax and penalty-free, plus you essentially act as the borrower and the lender.
401(k) loans allow account holders to take out a loan up to $50,000 or 50% of the vested balance, whichever is less. The IRS requires the loan to be repaid within five years, or 15 years if the loan was used to purchase a home. The plan’s administrator sets the interest rate, but the interest is paid back into the 401(k) account. If a borrower defaults on a 401(k) loan, the IRS treats the loan balance as an early retirement distribution and issues income tax and a 10% penalty tax.
How do you apply for a 401(k) loan?
While employers are not required to allow 401(k) loans in their plans, many 401(k) plans allow loans to be taken out against accounts.
There are two ways to apply for a 401(k) loan.
First, you could contact your human resource department at your company and speak with someone. They will guide you through their process of obtaining a 401(k) loan from your account. Any paperwork and documentation will most likely be handled by an individual which may add time to the application process. However, you’ll get better information working with an actual person.
The second option is to apply through your 401(k) plan’s online portal—if they have one. Most online 401(k) accounts have a process to submit a 401(k) application. This process can be much quicker as everything is automated. The only downside is because a person isn’t monitoring your application, any questions you may have may take some research or calling into a customer service department to get answers.
Generally, it takes about one to two weeks for the approval process to go through. Once approved, you’ll get the loan terms, payment amount and schedule, and information on when you can expect to receive your funds.
How long does it take to get the funds from a 401(k) loan?
Once the approval process is completed, you’ll receive all of the information regarding your loan. Depending on your plan’s administrator and the method you elected to receive your funds, it could take anywhere from a couple of days to a week or two.
Most plans will issue payment two to three business days after the loan has been approved.
One option to have your funds sent to you is by a physical check. If you elect for this option, it may take an additional day for the check to leave your plan administrator’s facility to the post office. Then, you’ll need to wait for the typical mail delivery length for the check to make it to your house. Once received, it will need to be deposited into your account, which could take a day or two, depending on your bank.
A much quicker option is to have your plan’s administrator direct deposit the funds into your bank account. Once the loan is approved, it will take a couple of days to process the transfer. Then, it’ll only be a day or two before the funds show up in your account.
How does interest work on a 401(k) loan?
The great feature of 401(k) loans is that interest is paid back into your account. As opposed to an ordinary loan where interest goes into a bank’s pocket, the interest you pay on a 401(k) loan goes into the future you’s pocket.
Another bonus is typically the interest rate you’re “charged” on a 401(k) is higher than the rate of return you’d see on the market. Sure it’s your money being paid back at that higher rate, but you can ensure you’ll be replenishing your 401(k) to even higher amounts by the time the loan is paid off.
Plus, as you’re replenishing your 401(k) balance with each payment, that balance will continue to grow as the investments grow.
What are the terms of a 401(k) loan?
The length of 401(k) loans is determined by the IRS. Typically, 401(k) loan borrowers must repay the loan within five years to avoid taxes and penalties.
If you take out a 401(k) loan in order to buy a house, say cover the down payment, the IRS will extend the repayment period to 15 years. This helps to stretch out the payments into smaller amounts. Although the opportunity cost of delaying the full repayment is the missed growth opportunity, your 401(k) would have experienced.
Additionally, recent legislation passed due to the COVID-19 pandemic has extended the standard repayment length from five years to six years, giving borrowers an extra year to repay their loans. An additional note to this legislation is that loan amount limits have increased to $100,000 or 100% of the vested balance.
What happens when you default on a 401(k) loan?
Defaulting on any loan is never a good idea. Fall behind on ordinary loans, and you’ll damage your credit, and the loan balance will be sent to collections.
Fail to repay your 401(k) loan; you may be in even worse trouble. Your credit won’t be impacted; however, the IRS will deem the defaulted loan as an early retirement distribution. The loan balance will be considered income and be taxed at the income tax bracket the loan and your annual income put you in. Additionally, the IRS will issue a 10% penalty tax on the balance as well.
Fail to pay this within the IRS’s timeframe, and you’ll be subject to backed tax penalties and interest.
For this reason, it’s essential to know how you’re going to repay the loan as soon as possible.