Internal Revenue Service (IRS) regulations prohibit using funds in a 401(k) plan account as collateral for a loan, but it is sometimes possible for an individual to obtain a loan directly from their 401(k) account.
Key Takeaways
- The IRS doesn’t allow you to use funds in your 401(k) account as collateral for a loan.
- Under certain circ*mstances, you can borrow from your 401(k) if your plan permits.
- Taking a loan from your 401(k) comes with drawbacks that need to be considered carefully.
Accessibility of 401(k) Funds
The 401(k) plan has some great features, such astax-deferred status,matching contributionsand catch-up provisions for older savers.That said,one of their drawbacks is lack of accessibility. The structure of a 401(k) account is different from that of a traditional individual retirement account (IRA).
While an IRA is held in the name of the account holder, a 401(k) account is held in the name of an individual's employer on the individual's behalf. The specific 401(k) plan offered through the employer governs the circ*mstances under which individuals can withdraw money from the account, and many employers only allow early withdrawals in the event of severe financial hardship. This basic structural fact regarding 401(k) accounts is one of the main factors that present obstacles to using account funds as collateral for a loan.
One of the other primary reasons stems from the fact that these accounts are specifically protected from creditors by the Employee Retirement Income Security Act, or ERISA. Therefore, if a 401(k) were used as collateral for a loan, the creditor would have no means of collecting from the account in the event the borrower defaulted on the loan payments.
Borrowing From a 401(k)
In lieu of using a 401(k) account as collateral, an individual may be able to borrow the money theyneedfrom the 401(k) account itself. You are only allowed to take a loan from your 401(k) when the initial plan documents that established the employer-sponsored plan explicitly state that a loan provision is included. You can request this information from your company's human resources contact or your 401(k) plan sponsor.
After determining that a loan against your 401(k) is available, make a loan request for the amount you need up to your available limit directly to your 401(k) plan sponsor. For instance, if your 401(k) plan is managed by Fidelity Investments, direct your request there.
Once your plan sponsor processes and approves your 401(k) loan request, you receive a check or direct deposit for the amount requested, minus any loan origination fees.
Borrowing from a 401(k) has both benefits and drawbacks that need to be weighed carefully.
Pros
Unlike a personal loan from a conventional lender, where you make repayment (including interest) to a bank or credit union, your 401(k) loan repayments go back into your own account.
The interest paid on 401(k) loans is substantially lower than the rates on an unsecured loan offered by a lender, and it benefits you as the borrower as opposed to an outside lender.
A loan from a 401(k) does not require an extensive credit application, credit check, or underwriting, and you receive funds in a few business days.
Cons
While 401(k) loan proceeds are not taxable as long as you are employed by the company, funds are considered a taxable distribution if you do not pay them back in full after you terminate employment. If you are younger than 59½, a distribution results in a 10% tax penalty, as well.
A loan against your 401(k) lowers your retirement savings, which, in a down market, can be difficult to replenish.
Depending on your time frame until retirement, and the amount of time you take to repay, your account may never make up the loss of those funds, or the appreciation opportunities.
Even though loan payments go back into your 401(k) account, additional paycheck deferrals can be detrimental to the cash flow you need for other life expenses.
Source: Internal Revenue Service
401(k) Loan Limits
The IRS allows an individual to borrow whichever is less: up to $50,000 or 50% of the account's vested value (the amount in an individual's 401(k) that they would receive in the event theyleft theirjob).
Some plans require a spouse's consent before a loan of more than $5,000 can be granted.
While this restriction is the same for nearly all employer-sponsored plans, companies vary on which limitations are placed on the use of loan proceeds. With some 401(k) plans, employees are only allowed to take a loan to pay for medical expenses not covered by insurance or education expenses for a spouse or child. In other cases, they can use loan funds for a down payment on a home purchase or for general financial hardship.
The 50% loan limit may not apply in the event an individual's vested account value is less than $20,000.In that case, the individual may be allowed to borrow as much as $10,000 from the account provided the vested account value is at least $10,000.
Repayment Terms for 401(k) Loans
Just like other loans,funds obtained from a 401(k) account must be paid back, plus interest. Unlike a loan from a bank, the interest paid goes to the 401(k) account itself. With the majority of employers, loan payments cannot be extended past a five-year term and are made through paycheck deferrals. In some cases, such as a loan for a down payment on a home, repayment may be extended past the five-year maximum.
If an individual leaves theirjob prior to repaying the loan, theyhaveuntil October of the following year (the due date of your tax return, including extension) to put the money back. If the loan is not repaid within that time frame, it is designated as apremature distribution of funds and is thus subject to income taxes, plus a 10% early withdrawal penaltyfor borrowers under age 59½.
