How do 401K loans work? Our complete guide is going to cover everything you need to know.
Emergencies can happen. However, many people may not be in the position they need to be in to handle what life throws at them. A good emergency fund is one that covers at least 3 to 6 months of all expenses.
Sadly, many Americans don’t have this amount saved up for an emergency. In fact, 51% of Americans have less than 3 months of expenses worth of emergency savings. That is why some people turn to 401(k) loans when they find themselves in a tough spot. However, a 401(k) loan is not a financial decision that should be taken lightly.
How do 401K loans work, though? And is this the best type of loan for your specific situation? Below, you’ll discover answers to both these questions and many others you may have about 401K loans. We’re here to empower you with financial resources like this one – so buckle up, and keep reading to learn all about how 401k loans work!
What is a 401(k) Loan?
First, what is a 401K loan?
Many people don’t even know what a 401(k) loan is. That is why it is important to understand the basics when learning about this financing opportunity. A 401(k) loan is a type of loan that allows people to tap into their 401(k) plan.
When a person takes funds out of their 401(k) due to an immediate emergency need, it is known as a hardship withdrawal. A hardship withdrawal refers to the emergency removal of funds from a retirement savings account as a result of heavy and immediate financial need. To fully understand how 401K loans work, keep reading below…
How Do 401(k) Loans Work?
So – how do 401K loans work, exactly?
If you have a 401(k) plan through your employer, then you may have the opportunity to borrow against your retirement savings account. We know we are going to sound like a broken record but every employer is different!
That means every plan is different. So while you may have the opportunity to borrow against your account with one employer, that may not be a possibility with another employer. Unlike a standard loan like a personal loan, borrowing against your 401(k) does not require a credit check. That means there shouldn’t be an impact on your credit.
If your plan allows loans and you have a vested account balance in your 401(k), then you will likely be able to borrow against it. The vested account balance refers to the portion of a retirement savings account that the account holder owns.
However, this is still a loan which means you will need to repay your loan with interest within a specific timeframe. Basically, you are borrowing money from yourself and paying yourself back (with interest!).
Is There a Limit on a 401(k) Loan?
Now that you know how 401K loans work, you may be wondering…is there a limit on what you can pull out of your account?
Since each plan is different they will have their own borrowing limits. However, the Internal Revenue Service (IRS) does set a maximum limit that all plans must follow. The IRS loan balance maximum allowable amount is no more than $50,000. Generally, people will be able to borrow $10,000 or 50% of their vested account balance (within IRS limits).
With that said, you shouldn’t pull out the maximum amount allowable just for the sake of freeing up some cash for spending. When you take out a 401K loan from your retirement savings, you set yourself back dramatically. These should only be used in emergency situations. And before pulling the trigger, you should explore the advantages and disadvantages of a 401k loan below…
Advantages of a 401(k) Loan
When you make a financial decision, it is important to look at both the pros and cons of it. That’s because weighing out the good and the bad can give you a better understanding of your decision. You will also want to talk to a professional! Some benefits to consider when you borrow money from your 401(k) include
When you think of getting a loan, you will typically think of a loan application. However, when you borrow from your 401(k) you don’t need to submit an application. That’s because you are borrowing money that’s coming from your own money in your account. In fact, you may not even need to explain why you are taking the funds out. However, your plan administrator will expect some details, just not as much that goes into the typical loan process.
No Credit Score Impact
When you borrow funds from your 401(k) you won’t need to worry about a hard inquiry. That means you won’t need to deal with the negative impact that comes along with hard inquiries. On top of that, you won’t need to worry about your credit score impacting whether or not you can get the 401(k) loan. That’s because your plan administrator will not report your loan repayments to credit reporting agencies like Transunion, Experian, or Equifax (these are the three main ones).
Potentially No Taxes
When you take funds out of your 401(k), you may need to pay income taxes depending on the type of 401(k). On top of that, you may face a 10% early withdrawal penalty if your distribution isn’t qualifying. You will likely not need to deal with these taxes or penalties as long as you repay the loan in time!
Disadvantages of a 401(k) Loan
While it is important to know the benefits that come along with a 401(k) loan, it is important to understand the drawbacks. Some of the drawbacks to keep in mind include:
You May Not Have the Option
Not every employer gives people the option to borrow against their 401(k). That means that it may not even be a possibility for you to consider. That is why you will want to get in touch with your plan administrator to see if you have the option to do this.
Loan Balance Limits
When you try to borrow from your 401(k) you will run into borrowing limits. The IRS sets borrowing limits for this type of loan. The borrowing limits you’ll face will be either $50,000 or 50% of your owned portion (whichever is less).
Giving Up Bankruptcy Protection
If you are dealing with financial problems to the point where you are considering taking from your 401(k) account then it’s especially important to keep this drawback in mind. The funds in your 401(k) plan are safe from creditors in the event of bankruptcy. However, if you borrow funds from your 401(k) but still end up filing for bankruptcy, any withdrawn funds from your 401(k) lose out on that protection.
Now That You Know How 401K Loans Work, is it the Right Approach for You?
The best time to consider this type of loan will depend on your specific financial situation. That is why you will want to get in touch with a professional to answer any and all questions you may have. They can consider the details of your current situation in order to give you the best personalized advice that they can. There are plenty of times that people consider this loan opportunity. People use funds from a 401(k) loan to:
- Put towards household expenses
- Use towards a down payment
- Pay off debt
- Handle medical expenses
- Put towards home repairs
- Use for education costs
With that said, there are alternatives to the 401 K loan – we’ll discuss those below:
401(k) Loan Alternatives
People typically turn to 401(k) loans when they find themselves stuck between a rock and a hard place. However, there are some alternatives to consider that may be able to provide the financial support you are looking for without dipping into your retirement savings. Some alternatives to a 401(k) loan include:
- Home Equity Loan: This type of loan allows borrowers to borrow against the equity they have in their homes. This is a great option for people that want to use their loans to go towards housing costs like home improvements or home repairs. Another benefit of this loan is the fact that interest may be able to be a tax deduction.
- Personal Loan: Many people shy away from personal loans because of the fact that they require a high credit score in order to get the best terms available. However, if your credit is in good standing, then this is definitely an option you will want to consider. One of the best parts about these loans is the fact that they can be used for pretty much anything. Not only that, but they can be unsecured which means there would be no risk of losing anything for collateral
If you’re not sure still which loan is best for you to borrow money from, get with a financial professional to discuss all your options – this is the best way forward.
Final thoughts on How 401K Loans Work
A 401(k) loan is a type of loan that allows people to tap into their 401(k) plan. People typically take funds out of their 401(k) due to immediate emergency needs. However, these loans are different from traditional loans which is why it is important to keep the pros and cons of this option in mind. Not every employee will have the option to use this loan since every employer is different.
Now that you know how 401K loans work, you should feel more confident in choosing this type of loan or going with a different option: such as a personal loan or home equity loan. Weighing the pros and cons of early withdrawal and income taxes will help you make the right choice.
But, the best way to find the right financing option for your situation is by getting in touch with a professional. They will be able to answer any and all questions you have while taking into consideration your specific situation!