What is a 401(k) Loan?
A 401(k) loan is simply borrowing against a 401(k) account, with the understanding that, just like with all loans, the money borrowed needs to be repaid. A company or individual can borrow money from their 401(k) retirement account.
Provided that the money borrowed is returned, the retirement plan fares well and may enable the individual to live off the money accrued for the remainder of their life. A problem arises when individuals borrow money that they are unable to return to the account, posing danger to their retirement plans.
Understanding the Rules of a 401(k) Loan
Because a 401(k) account is created using money taken off regularly from a worker’s regular income, the employer enjoys a certain amount of discretion in relation to setting up the rules for taking out a loan from the account.
In most cases, a 401(k) loan cannot exceed 50% of the 401(k) balance or cannot exceed $50,000. Whichever amount is smaller is usually the biggest loan that an individual can borrow.
Every 401(k) loan plan involves certain loan administration requirements. They include:
- Never exceeds the accepted amount under that plan
- Setting a commercially reasonable interest rate on the loan
- Creating a written agreement and documentation for each loan
- The loan must be repaid within five years
- Loan payments must be made at least four times per year and each payment total must be equal, with principal and interest included.
There is not a set number of 401(k) loans that an individual can take out. However, the company the individual works for may choose to include a finite number of loans or a finite total amount that they can borrow regardless of how many loans are taken.
The Potential Dangers of 401(k) Loans
The biggest danger to taking a 401(k) loan is the inability to pay the loan back on time or sending the loan into default. A loan that is not paid back on time is subject to fees, penalties, and taxation. If the individual changes jobs before the loan is repaid, the outstanding balance is considered a distribution if not paid back in full within 60 days of leaving the company. Thus, the balance of the 401(k) that is owed to the worker will be accordingly reduced.
Before an individual decides to take out a 401(k) loan, it is important to be certain that the loan is going to be used for something important and that the individual will have the time and the means to repay the loan in full before leaving the company or retiring.
In most cases, 401(k) loans are used to repay other debts, which can leave the individual exposed and/or accruing even more debt that can’t be paid back. The best reasons for taking out such a loan are sudden or unanticipated expenses such as medical bills or repairs to damaged property, such as a home.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: