Are you thinking about taking a 401(K) loan? 401(K) loans give you access to money without using private loans. With a 401(k), there will be no lengthy loan application processes, credit score checks, high DTI ratio requirements, or requirement of a stable income and assets. The simplicity of 401(K) loans, however, comes with its challenges and terms.
If you are thinking about taking a 401(k) loan, here are 8 things you need to know.
1. You must pay off your 401(k) loan in 5 years
Just like any other loan, 401(k) loans come with terms. If you are taking a 401(K) plan you will have a maximum of 5 years to pay it off. Some exceptions to this rule may be considered if the money was used to purchase your primary residence, according to the Financial Industry Regulatory Authority (FINRA). In this case, you might qualify for longer terms up to 25 years.
2. Some 401(K) plans do not have loan options
Before you take out a 401(k) loan or make arrangements to make a purchase hoping to borrow against your 401(k), you need to confirm if your plan offers loan options. Even if you have 401(K) benefits from work, it does not mean you can borrow from the account. Some 401(k) plan providers do not allow 401(k) loans.
Plan providers are not required to offer 401(K) loan services. If your plan does not have this option, you will be out of luck. As you are signing up for your retirement plan, make sure that you understand all terms of the plan and loan servicing options.
3. A defaulted 401(K) loan becomes a distribution
One of the biggest risks that come with 401(k) loans or any other form of debt is the risk of default. When you default on a private loan, you can easily experience foreclosure, debt collections, and or bankruptcy.
What makes taking a 401(k) loan a great choice is that no banks involved, mortgage brokers, etc. It is you who is borrowing from your retirement account. The money you take out is considered a loan because your retirement savings should not be used until you have retired.
That is why you must pay it off in a given time, typically 5 years. Failure to bring the money back and restore your retirement savings account to a pre-borrowing state will turn into a default.
If you default on your 401(K) loans, the loan will become a distribution, and 401(K) normal distribution rules will apply. If default on a 401(k) loan and you are under 59½, you will pay a 10% tax penalty and income tax.
Read more: What happens when you default on a 401(k) loan?
4. You can borrow the lesser of 50% of the vested amount or $50,000
When taking a 401(K) loan, you take money from your retirement savings. This means you cannot borrow more than the vested amount available in your account. In addition, you will not be permitted to empty your entire retirement savings.
So, how much can you borrow from your 401(K)?
The Internal Revenue Service(IRS) allows a maximum of $50,000 or 50% of your vested amount whichever is lower. Any amount that is not vested from your employer matching contributions will not be used when calculating this 50%.
For example, if you have a vested amount of $120,000 you can borrow up to $50,000. This is because the $50,000 is less than 50% of your vested amount which is $60,000. On the other hand, if your vested savings are $30,000, you can borrow up to $15,000.
The only exception to this rule occurs when 50% of the vested amount is less than $10,000. In this case, you will be allowed to borrow up to $10,000.
Read more: How much money can you borrow against 401(K) plans?
5. You might be required to pay off your 401(k) loan in full if you leave your job
One setback of taking a 401(K) loan is that the 5-year time limit will no longer hold once you quit your job. Your 401(K) loan is tied to your job and plan provider. Once you quit your job, it becomes harder to enforce the terms of the loan and collect your loan payments.
After leaving your job, the 5 years allowed to pay off your 401(K) loan will no longer apply. Instead of having 5 years to pay off your 401(k) loan, you might be required to pay off the remaining balance upon termination or be given a 60-day grace period. If your employer terminates your employment, you will have up to the due date of your federal tax returns of the year the unpaid balance became a distribution.
If you cannot pay off the remaining 401(K) loan balance in a timeframe allowed by the IRS, the defaulted 401(k) loan amount will become a distribution.
6. The 401(K) loan comes from your retirement savings and all payments including interest go back into your account
401(K) loans differ from other private loans. For regular conventional loans, the lender will require a credit score, employment, and good DTI ratio, and other assets to approve your creditworthiness.
Taking a 401(K) loan, on the other hand, the process is quite different and much simpler. The money comes from your account and the payments plus interest go back into your account.
In other words, you are borrowing money from your retirement plan and paying interest to yourself. This is why some people consider 401(k) loans as taking money out of your account and putting it back it with interest.
7. You will pay a 10% penalty plus taxes if you default on a 401(K) loan
All debts share one major risk: Failure to pay off the debt. A 401(K) loan is not an exception to this risk.
When you default on your 401(K) loan, the unpaid balance becomes a distribution. If you are not 59½ or older, you will pay a 10% early withdrawal penalty for early withdrawal, unless you meet The IRS exceptions.
8. Consent from your spouse may be required
Most employers require consent from your spouse before you are allowed to take a 401(K) loan. Your retirement savings are there to benefit you and your spouse. So, if you are taking a 401(K) loan, approval from your spouse may be required before you the company approves your loan application.
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