What Is A 401k Loan?
401(k)s are a way to reduce income because contributions are made with pre-tax dollars. All the gains, and dividends inside of a 401(k) account are tax-deferred. However, there is a catch. Funds in a 401(k) are not accessible without penalty until age 59 ½. Furthermore, most companies will not let employees withdraw funds from their 401k accounts until they are not longer working at the company. Another option does exist.
A 401(k) loan is a just like any other loan. The owner of the 401k borrows a certain amount of money from their 401k. How much can be borrowed depends on the plan document which can vary from company to company. However, in all cases, no more than the total amount invested in the 401(k) can be borrowed. More typically, only a certain percentage may be borrowed. In some cases, loans up to 75% of the total value may be available, and in other cases, as little as 25% of the account can be borrowed.
Once the loan has been taken, the person is required to make monthly payments to repay the loan with interest. However, the payments do not go to a bank or lender, but rather back into the investor’s 401K account. In this manner, many people consider a 401(k) loan to be paying interest to yourself. Unfortunately, while this is true, it is also true that the value borrowed is not invested while it is loaned and cannot benefit from investment gains.
Just like a regular loan, there are consequences for not repaying a 401k loan. With a regular loan, the lender may be able to repossess some collateral and will also harm the borrower’s credit report by reporting the non-payment of the loan. However, in the case of a 401(k) loan, there is nothing to repossess (it was the person’s money in the first place), and no credit report entries are made. Unfortunately, something just as unpleasant can happen.
401k loans that are not repaid in timely fashion are considered distributions. Assuming the person taking the loan is over 59 ½ years old, that means that taxes are due on the amount not repaid. For borrowers under the age of 59 ½, not only are income taxes levied on the unpaid amount, but an early withdrawal penalty of 10% is assessed as well. Not repaying a 401(k) loan can therefore be very costly.