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- Can I take a loan from
my 401(k) plan?
- How do 401(k) loans
work? How much can I borrow?
- How is my 401(k) loan
rate determined?
- What if I default on
my loan?
- How long do I have
to repay my loan?
- Is it a good idea to
take out a loan from my 401(k) plan?
1. Can I take a loan from my 401(k) plan?
Maybe.
Your 401(k) plan is intended to be a long-term retirement savings plan,
but the government recognizes that many employees would be reluctant
to save in a 401(k) without the possibility of getting their money out
before retirement. So employers are allowed to decide whether or not
to offer a loan feature. As a result, loans are not universally offered.
Check
with your human resources department or read your Summary Plan Description
to find out if your plan offers loans.
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2. How do 401(k) loans work? How much can
I borrow?
When
you take a loan from your 401(k) plan (if your plan permits them), you
essentially are borrowing from yourself.
You
will have to pay interest on this loan, but the rates are generally
competitive with the retail market. What's more, the interest payments
go back into your account. The most common loan interest rate benchmark
used by 401(k) is the prime lending rate plus an additional percentage
point or two, the Profit Sharing/401(k) Council of America says. Typically,
the interest rate charged on a loan is competitive with or cheaper than
commercial lending rates.
Repayments
of loan principal and interest are deducted directly from your paycheck
after taxes and deposited in your 401(k) account.
With
plan loans, there are no taxes or penalties owed when you take the money
out. However, you do repay loans with after-tax money, not pre-tax as
with your regular 401(k) contributions. Although legally, loans can
be allowed for any reason, many plans permit them only in specific,
approved situations such as paying college tuition or buying a house.
Loans
are generally limited to $50,000 or half of the value of your account
(your contributions and vested employer-match contributions) whichever
is smaller. There might also be a minimum amount imposed by your company.
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3. How is my 401(k) loan rate determined?
Most
commonly, the interest rate charged on a loan is based on the prime
lending rate plus an additional percentage point or two, according to
the Profit Sharing/401(k) Council of America's 43rd Annual Survey
of Profit Sharing and 401(k) Plans. More than 87 percent of plans
use this benchmark for determining loan rates.
Other
common benchmarks used for 401(k) loan rates include commercial lending
rates, certificate of deposit rates and guaranteed investment contract
rates.
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4. What if I default on my loan?
If
you fail to repay your loan, the remaining outstanding balance will
be considered a distribution. You will owe applicable federal, state
and local income taxes on the amount. You will also owe a 10 percent
early withdrawal penalty if you continue working for the same company
and are younger than 59ý, or if you leave your job before the year you
turn 55.
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5. How long do I have to repay my loan?
Typically,
most 401(k) loans must be repaid in five years. However, loans used
for the purchase of a home commonly have repayment schedules of 10 years.
Check with your benefits department for loan terms available to you.
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6. Is it a good idea to take out a loan
from my 401(k) plan?
This
depends on your particular situation and 401(k) plan. As a general rule,
it is advisable to investigate other loan sources (bank, mortgage company,
tuition loans from schools or government) before dipping into your 401(k).
Different
401(k) plans have different rules. Some do not allow loans, while others
may only allow them in certain cases. You should check with your human
resources or benefits department to find out whether your plan allows
loans, and under what circumstances.
If
loans are permitted, they are generally limited to $50,000 or half of
the value of your account (your contributions and vested employer-match
contributions) whichever is smaller. There might also be a minimum amount
imposed by your company. Repayments of loan principal and interest are
deducted directly from your paycheck after taxes and deposited in your
401(k) account. You will be charged interest for your loan, but you
are the ultimate beneficiary of those interest payments because the
interest is paid to your account. Typically, the interest rate charged
on a loan is competitive with or cheaper than commercial lending rates.
You
generally have to pay the loan back within five years, unless it is
used for the purchase of a primary residence, in which case you may
have longer. If you borrow to buy a house, a 10-year repayment schedule
is typical. Check with your benefits department for loan terms available
to you.
While
it may seem like a good idea to borrow from yourself, there are actually
some big disadvantages.
- The
money you withdraw no longer earns compound interest, so your overall
account will be much smaller when you retire, especially if you also
stop making contributions while you are paying off your loan.
- Because
you repay the loan with after-tax dollars, and because you will have
to pay taxes on your 401(k) balance when you finally withdraw it in
retirement, you will be paying taxes twice on the money used to pay
back the loan.
- If
you quit your job or are fired you will probably have to pay back
the full amount of the loan right away (and that's likely when you
probably need the money the most). If you don't -- if you default
on the loan -- it will be treated as an early distribution from your
plan and you will have a hefty bill on your next tax return -- federal,
state and local taxes on the entire amount, plus a 10 percent penalty
if you leave your employer before the year you turn 55.
- When
your loan payments are deposited directly into the account they don't
necessarily go back into the funds they were taken out of, so you
have to be sure to rebalance your portfolio to keep your investment
strategy on track.
If
you have no choice but to take a loan on your 401(k), keep the following
points in mind to safeguard your nest egg:
- Pay
the loan back as soon as possible.
- Try
to keep making contributions to the account even while you are paying
back the loan.
- Don't
default on the loan.
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