4 Crucial 401(k) Loan Rules You Should Avoid Breaking  

401(k) loan rules

Borrowing from your future isn’t a decision you should make lightly. But if you’re in a bind or your only other option is to take on high-interest debt, a 401(k) loan might be your best choice.

Taking out a 401(k) loan isn’t uncommon. According to a 2016 report by the Investment Company Institute, 17 percent of 401(k) participants have loans outstanding on their accounts.

Before you do, however, consider these four 401(k) loan rules that could limit your borrowing power and cost you more than just interest and fees.

401(k) loan rules that can backfire

1. You’re limited in how much you can borrow (if at all)

Although the Internal Revenue Service (IRS) allows 401(k) plans to offer loans, it’s not a requirement. So, your 401(k) administrator might not allow you to borrow from your retirement account at all.

If it does, you’re limited in how much you can take out. According to IRS rules, you can borrow the lesser of the following:

  • The greater of $10,000 or 50 percent of your vested account balance
  • $50,000

For example, if you have a $50,000 vested balance in your 401(k) account, you can borrow only up to $25,000.

Note: Vesting is a process that allows you, the employee, to get full rights to some or all of your employer’s contributions to your 401(k) plan. Some employers give 100 percent vesting from the start. Others might require that you work for the company for a period before you gain access the full contributions.

What you can do: Check with your 401(k) plan administrator to see if loans are available and what fees, taxes, and penalties might apply. Then, calculate how much you can borrow to determine if it’s enough for your needs.

2. If you default, it could mean extra taxes

When you borrow from your 401(k), you’re required to pay back the loan in five years or less. The only exception is if you use the funds to buy a house as your primary residence. For this use, the IRS allows longer repayment periods.

In either case, if you don’t make payments at least quarterly and repay the loan in full by the deadline, your employer will report the entire amount of the loan as a regular distribution.

If you’re not 59 and a half yet, that distribution could be subject to income tax and a 10 percent early withdrawal penalty.

For example, say you borrow $10,000 and don’t pay the 401(k) loan back within five years. If your effective tax rate is 15 percent and you’re not exempt from the 10 percent early distribution penalty, you could owe $2,500 (25 percent) when you file your taxes for the year.

What you can do: Calculate the potential penalties if you can’t repay the loan on time. Then, identify lower-cost alternatives to a 401(k) loan that might have lower fees and interest.

3. Leaving your job could cost you

If you leave your job or get laid off, your plan administrator can require that you pay back the full amount of the loan within 60 days, regardless of your original repayment plan.

If you don’t repay the loan by the deadline, the employer will treat the amount you borrowed as a regular distribution, making it potentially subject to income tax and the 10 percent penalty if you’re not yet 59 and a half.

The risk of defaulting on the loan is high too. In a 2015 study, the National Bureau of Economic Research found that 86 percent of people who terminated employment with 401(k) loans outstanding defaulted.

If your job isn’t stable or you plan to search for a new job in the next five years, a 401(k) loan might not be your best option.

What you can do: Assess how stable your job situation is. If you have any reason to believe you might switch jobs or lose your job during the repayment period, look for alternatives that have more predictable repayment terms.

4. You could lose potential investment earnings

When you take money out of your 401(k) for any reason, that money is no longer working for you. That’s because with some 401(k) plans, the amount you borrow doesn’t go back into your investment account until the loan is paid in full.

For example, if you borrow $10,000 with a 5 percent interest rate, you’ll pay $1,323 in interest over five years. If you earn 7 percent annually on your 401(k) investments during that same time, you’ll also lose out on $4,026 in earnings on the $10,000 you borrow.

So, even if your 401(k) loan fees are low, the total cost of the loan between interest and lost earnings in this example is $5,349.

That said, it could work to your advantage if the market is down during that time. Since 401(k) funds are usually invested in a mixture of stocks and bonds, the movement of those investments will affect your balance.

For example, say your 401(k) investments have an average annual loss of 4 percent over the loan’s five-year repayment term. In this case, the $10,000 loan will save you from a loss of $1,846, and you’ll essentially make $523 on the loan.

What you can do: There’s no way to predict how the stock market will perform. But you should ask yourself whether you’re willing to take on the risk of losing that investment growth. Because of the time value of money, it could take you years to make up for the forfeited growth.

You also should check with your 401(k) plan representative to see if they credit your monthly payments to your 401(k) account or wait until the entire balance is repaid.

Know how 401(k) loan rules affect you

401(k) loans can work in your favor, but they also can carry hidden costs. That’s why it’s crucial for you to consider all the potential scenarios before you apply for one.

Make sure you understand how 401(k) loan rules can add extra costs and risks and then decide whether you can afford them. That way, you’ll be prepared if things go south.

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