How Do 401(k) Loans Work?

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.

Understanding 401(k) Plans

Before we dive into what it means to take out a 401(k) loan, it is important to know what a 401(k) plan is. A 401(k) plan is a type of retirement account that employers may offer. Not every employer offers this type of retirement savings opportunity. However, many do! It’s also important to note that employers may match a portion or all of their employee contributions. Since every employer is different, the rules will vary. This retirement account is an investment account. That means when people contribute funds into this account, they will need to decide which investment options the funds will go towards.

Many employees enjoy 401(k) plans because of the fact that they come with tax advantages. However, the specific tax advantages that the 401(k) plan will be able to provide will depend on the type of 401(k) plan. There are two main types of 401(k) plans. There are:

  • Traditional 401(k)s
  • Roth 401(k)s

Regardless of the type of account, there are rules that come along with these plans. One of the biggest rules to keep in mind is that there are contribution limits. The 401(k) contribution limits for 2021 were:

  • $19,500 for employees under 50 years old
  • $26,000 for employees over 50 years old

However, these limits are subject to change. That is why for 2022, 401(k) contribution limits are:

  • $20,500 for employees under 50 years old
  • $27,000 for employees over 50 years old.

What is a Traditional 401(k)?

A Traditional 401(k) is what comes to mind for most people when they think of a 401(k). A Traditional 401(k) is funded with pre-tax dollars. Pre-tax dollars means that taxes have not been applied to the funds before they are put into the retirement account. That’s important because that means the contributions that an employee makes can be considered as a tax deduction. A tax deduction can reduce the overall amount of taxable income that an employee needs to pay taxes on. Let’s look at an example for some more context!

Let’s say one year your taxable income (before any tax deductions) was $46,000. In that same year, you made a contribution towards your Traditional 401(k) of $7,000. Since the funds you contributed were pre-tax, you can count that $7,000 contribution as a tax deduction. That would reduce your overall taxable income down to $39,000. That means you would pay taxes on $39,000 instead of $46,000, which results in paying less taxes!

However, since the tax benefits are available right away when it comes to a Traditional 401(k), it will be a little bit different down the line. That’s because once it’s time to withdraw funds from the account (known as taking a distribution), they will be taxed at the standard income tax rate.

What is a Roth 401(k)?

Another popular 401(k) retirement account option is a Roth 401(k). These accounts are funded with after-tax dollars. After-tax dollars means the funds that go into this account have already had taxes applied to them. While employees won’t be able to count contributions as a tax deduction, the benefits come down the line. That’s because the funds you take out from this account will not face any additional taxes (as long as they are eligible). That means they will not be taxed at the standard income tax rate and you won’t have to pay taxes on them.

What is a 401(k) 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 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.

How Do 401(k) Loans Work?

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 inside of 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?

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).

Pros 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:

  • No Application
  • No Credit Score Impact
  • Potentially No Taxes

No Application

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!

Cons 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
  • Loan Balance Limits
  • Giving Up Bankruptcy Protection

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.

When is the Best Time to Consider a 401(k) Loan?

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

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
  • Personal Loan

Home Equity Loan

If you are a homeowner, you may want to consider taking out a home equity loan. This type of loan allows borrowers to borrow against the equity they have in their home. Homeowners have the option to tap into their home’s equity with this type of loan. 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 towards pretty much anything. Not only that, but they can be unsecured which means there would be no risk of losing anything for collateral!

Frequently Asked Questions

Understanding what it means to borrow money from your 401(k) can be tricky. That is why a lot of other people had questions when learning about this topic that you may have too!

Is it Bad to Borrow Money from Your Retirement Savings Account?

When it comes to borrowing money from your retirement savings, it’s a good rule of thumb to avoid doing this. That’s because you are taking money away from an account that is technically supposed to be only for your retirement. While you may repay the loan, you run the risk of running into issues and dealing with drawbacks that come along from this financial decision. You will want to talk to a professional to get a better understanding of what it means to borrow from your 401(k) as well as what alternatives may be better for your situation.

Do You Need to Pay Income Taxes on Your 401(k) Loan?

As long as you make loan repayments on time and within the specific loan terms, you will not need to pay income taxes on the funds you take out. That’s because any funds you take out from a 401(k) loan is tax-exempt!

What is the Interest Rate on This Type of Loan?

We know we are repeating ourselves but every employer 401(k) plan is different! That means that the interest rate that you will have to deal with depends on the plan you have. However, it is determined by taking into consideration the current prime rate.

Bottom Line

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 a traditional loan 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. 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!

Article References

https://www.wellsfargo.com/financial-education/basic-finances/manage-money/cashflow-savings/emergencies/

https://www.cnbc.com/2021/07/28/51percent-of-americans-have-less-than-3-months-worth-of-emergency-savings.html

https://www.investopedia.com/terms/1/401kplan.asp

https://www.investopedia.com/retirement/401k-contribution-limits/#toc-employer-contributions

https://www.finra.org/investors/learn-to-invest/types-investments/retirement/401k-investing/401k-loans-hardship-withdrawals-and-other-important-considerations

https://www.investopedia.com/terms/h/hardship_withdrawal.asp

https://www.creditkarma.com/personal-loans/i/loan-from-401k#what-is-a-401k-loan

https://spconsultants.com/resources/what-does-vesting-mean-what-is-a-retirement-plan-vested-balance

https://www.thebalance.com/pros-and-cons-of-borrowing-money-from-your-401-k-2388219#toc-pros-of-borrowing-from-your-401k-explained

https://www.investopedia.com/ask/answers/12/are-401k-loans-taxed.asp

https://meetbeagle.com/resources/post/what-is-the-interest-rate-on-a-401k-loan

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