Congress established qualified retirement plans such as 401(k)s to encourage employees to save and invest for their retirement years. These plans utilize a carrot-and-stick approach to promote their usage. The carrot is the ability to deduct 401(k) contributions from your current income and defer taxes until money is withdrawn. The stick is a 10 percent tax on early withdrawals (generally defined as distributions before age 59 1/2 ), subject to certain exceptions. 401(k) plans are allowed, but not compelled, to offer employee loans. These loans do not trigger income tax or the early withdrawal penalty, as long as the rules are observed.
If permitted by your specific 401(k) plan, you can borrow up to the greater of $10,000 or 50 percent of your vested balance, or $50,000, whichever is less.
Borrowing from a 401(k)
The amount you can borrow from your 401(k) depends on the vested balance, which is the balance that won’t be forfeited due to separation from your job. You can take more than one loan from your 401(k), assuming your plan allows loans. If you have an outstanding 401(k) loan, the $50,000 limit on a new loan is reduced by the highest outstanding loan balance during the one-year period ending on the day before the new loan minus the existing balance on the day you take out the new loan.
Time Limit for Repayment
In most cases, you must repay a 401(k) loan within five years. However, the time limit does not apply if you use the loan to help purchase or build your primary residence. Any unpaid balance after the five-year limit is treated as a taxable distribution subject to the early withdrawal penalty. You can get an extension of the repayment deadline during periods in which you are in the uniformed service. You must repay the loan in substantially level payments, no less frequently than quarterly, over the life of the loan. However, you can get up to one year of repayments suspended if you are on a leave of absence from your job. After you return from your leave, you must either increase the quarterly repayment amounts or make a lump-sum payment at the end of the loan term, since the loan term remains the same.
Interest on 401(k) Loans
When pulling money from a 401(k) via a loan, you are required to pay interest on the outstanding balance. The regulations call for the plan administrator to charge a “reasonable rate of interest,” which is open to some interpretation. Generally, the 401(k) loan interest rate is reasonable if it matches the one a commercial lender would charge you. The IRS suggests a reasonable interest rate would be comparable to the terms of similar commercial loans available locally. It has stated informally that a 401(k) loan rate that is 2 percentage points above the prime rate would be reasonable.
Whatever rate is charged, the interest you pay flows back into your 401(k) account. In other words, you are paying yourself interest when you borrow from your 401(k). One consequence of interest self-payments can be seen when you contribute the annual legal limit to your 401(k). The interest you pay to yourself isn’t subject to the contribution limit, so it allows you to put additional money into your 401(k) above the limit. Note that your 401(k) trustee may charge application and other fees when you take out a loan.
Loans Treated as Distributions
A 401(k) loan is treated as a “deemed distribution” to the extent that its balance has not been repaid by the deadline date, normally five years after the loan date. A deemed distribution is unlike a real distribution, as it is not a cash flow and cannot be rolled over into another account. Its sole purpose is to determine the amount of your tax and penalty exposure. Another circumstance that can trigger a deemed distribution is severance from your job. Your plan administrator can demand immediate repayment of the loan balance when you separate from your job. If you default on the loan, the balance will be treated as a deemed distribution. Some administrators might grant you a short grace period to repay the loan. If you can come up with some or all of the default amount within 60 days, you can contribute it to another 401(k) or an IRA, thereby reducing or eliminating the income tax (but not the penalty tax, if any) triggered by the deemed distribution.
Alternatively, a 401(k) plan might treat a defaulted loan as a “plan offset” that reduces the account balance by the unpaid portion of the loan. Unlike deemed distributions, the amount represented by the offset can be rolled over to another qualified account or IRA, canceling the tax and penalty. The rollover amount is not counted as a contribution, nor is it subject to contribution limits. To roll over a plan offset, you must come up with the money and complete the transaction within 60 days. However, as of 2018, if the plan offset is the result of severance or plan termination, the rollover deadline extends to the federal income tax filing date, including extensions.
Refinancing a 401(k) Loan
Regulations allow a 401(k) loan to be refinanced, at which time the loan balance can be increased, subject to the regulatory limits. The portion of the refinanced loan stemming from the original loan must be fully repaid within five years of the original loan date. This is true even if the original loan specified a term shorter than five years. If you increased the loan balance when refinancing, the additional balance is subject to its own five-year repayment period, separate from the original loan.
401(k) Loan vs Hardship Withdrawal
If you are experiencing a financial hardship, you might be eyeing your 401(k) as a source of funds. The IRS rules permit (but do not require) 401(k) plans to approve hardship withdrawals. Some hardship distributions are not subject to the 10 percent early withdrawal penalty, including ones made for medical expenses, permanent disability, IRS levy, qualified domestic relations order and certain other circumstances. If you take a hardship withdrawal for any other reason, you face the 10 percent penalty tax.
Should a hardship suddenly arise, you might be undecided as to whether to take a 401(k) loan or a hardship withdrawal. However, the IRS has simplified the decision: You must take a 401(k) loan, if available, before you take a hardship distribution, unless the loan would prohibit you from retrieving other funds required to address the hardship. This stems from the general rule that you, within reason, tap all other sources of funds before taking a 401(k) hardship distribution.
401(k) Loans: Pros and Cons
On the plus side, the ability to take out a 401(k) loan means you can temporarily access retirement funds without creating additional taxes or penalties. You can pay it back while paying yourself interest, thereby restoring your 401(k) balance in a way not available had you simply withdrawn the money. The disadvantages include the fact that some 401(k) plans do not offer loans, the tax-deferred earnings you forego during the loan period and the loan limits that might make the loan amount inadequate for your purposes.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.