What to know when borrowing from 401k?

If you need short-term liquidity, a 401(k) loan is one of the low-interest ways of borrowing money. As long as your employer allows 401(k) loans, you can take a 401(k) loan to help you with your financial needs. The good thing with 401(k) loans is that you don’t need good credit to qualify for a loan; you can get approved even with poor credit. Before taking a 401(k) loan, you should know the rules of borrowing from 401(k). 

If your employer allows 401(k) loans, you may be allowed to borrow 50% of your vested balance up to $50,000. Typically, you may be allowed up to five years to pay off the loan, and you must make substantially equal payments comprising the principal and interest. The 401(k) interest is set at one to two points above the prime rate, and it is paid back to your 401(k) account. If you quit your job, you will be required to pay off the loan a lot sooner, usually before the federal tax returns due date.

Can you borrow from your 401(k)?

The IRS allows 401(k) plans to provide 401(k) loans to their participants. This means that employers can decide to allow or not to allow 401(k) loans to their employees.

If your employer allows 401(k) loans, you can apply and be approved for a 401(k) loan in a few days. You can use the money to pay for college, medical expenses, or even for a big purchase such as your home or car.

If your employer does not allow 401(k) loans, you won’t be allowed to borrow against your retirement savings. However, you may be allowed to take a hardship withdrawal if you have an immediate need you want to satisfy.

If you have old 401(k)s left with previous employers, Beagle can help you take a 401(k) loan against your old 401(k) at 0% net interest. Simply rollover your old 401(k)s to us, and we will do the rest.

How much can you borrow?

The IRS sets limits on how much 401(k) participants can borrow against their retirement savings. Typically, you can borrow the greater of $10,000 or half of your vested balance, up to $50,000.

For example, if your vested balance is $200,000, you can borrow up a maximum of $50,000. However, if your 401(k) balance is $80,000, you can only borrow up to $40,000. Once you take a loan, the amount is deducted from your account balance, and you can rebuild the balance over time as you repay the loan.

How much interest will you pay on a 401(k) loan?

When you get approved for a 401(k), the IRS requires loan payments to be paid in substantially equal payments, which include principal and interest. The interest you pay on the loan is determined by the plan administrator, and it is set to one or two points above the current prime rate.

Since you are borrowing your own money, the interest is paid back to your 401(k) account. However, you will pay the loan interest with after-tax money, and you will be taxed again when you take a distribution in the future. 

How long do you have to repay the loan?

Generally, 401(k) loans have a repayment period of five years. However, you may be allowed a longer repayment period of up to 15 years if you are using the loan to buy your primary residence. You must make loan payments at least once every quarter.

You may be required to make loan payments through automatic payroll deductions. Sometimes, an employee may elect to repay the loan through a check, but subject to the plan administrator's approval. If the request is granted, you will be responsible for making loan payments on time.

What happens if you default on the 401(k) loan?

If you are unable to pay off the 401(k) loan, the loan will be considered to be in default, and trigger significant tax consequences. The outstanding loan balance will be considered a deemed distribution and will be subject to income taxes at your tax bracket, and an additional 10% penalty if you are below age 59 ½. 

For example, assuming that you are 54 years old, and you took a 401(k) loan of $40,000, out of which $10,000 is in default. If you are in the 20% bracket, it means you will pay $2000 in income taxes, and an additional $1000 in early withdrawal penalty. In total, you can expect to pay up to $3,000 in penalties.

The employer will issue IRS Form 1099 showing the amount of unpaid 401(k) loan and the taxes you owe. You will be required to include the unpaid loan as a taxable income when filing your annual taxes.

What happens if you leave your job with an unpaid 401(k) loan?

If you got a better job, or you were laid off or fired from your job, you may be required to pay back the loan a lot sooner than you had expected.

For example, if you leave your job in the third year of a five-year loan repayment period, you may be required to repay the outstanding loan before the federal tax due date. You can make a lump-sum payment to pay off the loan or increase the periodic loan payments to beat the April tax deadline.

If you can’t pay the loan by the tax due date, the plan will treat the outstanding balance as a distribution. The unpaid loan will be taxed at your tax bracket rate, and you could owe an additional 10% penalty tax if you are younger than 59 ½.