Understanding 401k loan rules is important to those faced with a need for cash and considering the idea of tapping a 401k retirement account. Many financial gurus maintain that 401k retirement accounts serve the singular purpose of providing a source of retirement income and advise against taking either early withdrawals or loans from them. Nevertheless, most plans (not all) do offer a loan option to plan participants.
Loans from 401k retirement plans have some advantages. There is no credit check and interest rates are low, usually only a couple of points above prime. Loan applications are usually simple and in some instances loans can even be applied for over the phone. According to information at the U. S. Securities and Exchange Commission web site, many companies now provide 401k debit cards to their employees for use in obtaining loans from their accounts.
Terms Included in 401k Loan Rules
Loans taken from 401k retirement accounts are subject to Internal Revenue regulations. According to the IRS Resource Guide – Participants – General Distribution Rules, generally participants may borrow up to 50 percent of their vested balance or $50,000 whichever is less. The minimum amount that can be borrowed is $1,000. Generally loans must be repaid within five years unless the proceeds are to be used as a down payment by first time home buyers. In that instance, the borrower is allowed up to 15 years to repay the loan. Loan repayments generally must be made through payroll deduction.
Acceptable Reasons for Borrowing under 401k Loan Rules
Loans from 401k retirement plans are generally permitted for only certain approved reasons. The 401k Help Center web site states that there are four common reasons under which loans are made available. Participants may borrow to pay college tuition for themselves, a spouse or their children. Loans are authorized for the payment of mortgage payments and expenses to avoid foreclosure. First time home buyers may borrow from a 401k plan to use the proceeds as a down payment. Finally, rules permit participants to borrow from a 401k plan to pay medical expenses not covered by health insurance.
Premature Distributions and 401k Loan Rules
As long as the borrower repays the loan according to the terms, there is no taxable event and no penalties associated with loans from 401k accounts. However, if the borrower fails to repay the loan as agreed, the proceeds become a distribution. 401k distributions before age 59-½ are subject to the IRS 10 percent 401k early withdrawal penalty and distribution amounts are considered taxable income.
Until a loan is repaid, the 401k retirement plan participant will not receive any of the earnings on the amount borrowed that would have accrued in absence of the loan. Even though the borrower in effect pays themselves back wit the interest the interest typically does not offset the loss in earnings. For that reason, taking a loan from a 401k account should be avoided if at all possible. Still loans are preferable to taking an outright premature hardship distribution which is an even more costly way to access 401k account funds. Those interested in applying for a loan from their 401k retirement plan should contact their plan administrator to determine if a loan option is offered, to learn how to apply and what the specific loan terms are under their particular plan.
