401k loans

401k loans
Pictorial representation of the proverbial nest egg

How does 401k loans work

401k contributors are allowed to access some of their savings in form of 401k loans. Most 401k plans allow retirement savers to borrow money from this account under specific circumstances. 401k plans may offer loans to retirement savers but are not legally obligated to include loan provisions in their plans.

The 401k loan is taken from the employee’s own retirement savings account with a clear intention of paying it back. Technically, this Individual is borrowing money from himself. However, this borrowing is still treated like any other non-personal loan and comes with set repayment terms and set interest payments.

Typically, This loan is paid within 5 years (except when taken for the purchase of a primary residence).

IRS caps Loans from a 401k to half the vested value of the retirement (maximum of $50,000-whichever is lower). You are vested up to 100% of your own contributions. Employers’ match (portion) will depend on the plan’s vesting schedule (Check plans policy).

If the borrower is married and needs to borrow more than $5,000 some plans may require spousal consent in writing. Spouses are entitled to a portion of the 401k funds when you divorce.

How many 401k loans can you take out

 Every 401k retirement plan is different, some plans allow for multiple loans option at a time, while others don’t, it all depends on the specified terms of the plan (up to the maximum set by IRS).

With multiple loans, the issue is not how much you can borrow but rather how much you can access at any given time.

 401k loans for house

 Technically 401k loan for a down payment for a house is allowed, however, the following factors and drawbacks need to be considered;

  • Borrowing limits and interest payments
  • Is it a penalty-free distribution from IRS for first-time homebuyers? Qualifying for this exemption is very difficult especially if you are in possession of other assets that can be used for your home purchase.
  • Even if you qualify for an exemption, this withdrawal will still be taxed as income.

Any other withdrawal for the purchase of a house before the age of 59½ years old will be deemed a “hardship” withdrawal and is subject to a 10% early withdrawal penalty on top of income tax.

 IRS rules 401k loans

 How are 401k loans repaid

This can easily be done via automatic payroll deductions, just the same way your 401k account is funded.

Technically, the payment of a 401k loan is similar to a regular loan and comes with a fixed schedule of principal and interest payments. However, the interest payments are credited back into the employee’s 401k account. At a minimum, payments for this loan must be made quarterly. You can only make payments with after-tax deductions from your paycheck.

 Maximum 401k loan amount

IRS sets the maximum amount that a participant can borrow from his account to 50% of the vested account balance or $50,000(whichever is less). However, some plans have an exception to the 50% limit for account balances of less than $10,000. In this instance, an employee can access up to the full $10,000.

What is 401k loan interest rate

This is the rate charged by the Plan sponsor on the outstanding 401k loan balance.

The interest charged varies between plans but is usually related to the current prime rate i.e. maybe a point or two higher than the current prime rate.

It’s important to note that interest charged on the outstanding loan balance is repaid back into the borrower’s own 401k account. Technically, this is a transfer from one pocket to the other, hence can’t be considered an expense or loss.

401k loans payback rules

The rules are as follows;

  • The loan must be paid within 5 years, or else IRS considers this a distribution. This accrues a 10% early withdrawal penalty and taxes accrue as this is considered income for that tax year. The only exception is if the loan is to be used to buy a primary residence (living full-time). In this case, some plans allow repayment of up to 25 years.
  • Payment must be made at least quarterly.
  • The plan sponsor may require the loan balance to be paid in full when leaving employment. If unable to pay, the sponsor will treat this as a distribution, hence subject to the 10% early withdrawal penalty and taxes. You can counter this by rolling over the balance of your 401k loan into an IRA or other retirement plan before the due date for filing a federal tax return.
  • You won’t pay any taxes or penalties on a 401k loan if you repay on time.

401k loans CARES Act

Please be advised this applies only to the tax year 2020

 In response to the coronavirus crisis of 2020, Congress passed the CARES act (Coronavirus Aid, Relief, and Economic Security Act of 2020, specifically section 2202) which waived the 10% early withdrawal penalty on 401k plans (up to $100,000) specifically for retirement savers impacted by COVID-19.

These impacted individuals will also be allowed to stretch the related income tax bill over 3 years. Alternatively, they can also roll the funds back into a 401k-type plan or an IRA within 3 years, and avoid the tax payments.

You are considered “impacted” by Covid19 if you meet any of these descriptions:

  • An Individual, their spouse, or dependents (for tax purposes) is diagnosed with the virus SARS-CoV-2 or with coronavirus disease 2019 (COVID-19) by a test approved by the Centers for Disease Control and Prevention.
  • The individual goes through adverse financial times out of being quarantined or furloughed, laid off, or work hours cut as a result of the pandemic.
  • The individual is not able to work due to a lack of child care resulting from the SARS-CoV-2 or COVID-19.
  • Individuals closed or reduced business hours due to the coronavirus.
  • Or other situations as deemed by the Secretary of Treasury.

Point 1 above is very specific and defined; either you, your spouse or your dependant must have been diagnosed with Covid19 using a specific test by a qualified person. Points 2-5 are more subjective.

What happens to 401k loans when you quit

 A 401k loan should be a major consideration when making a decision on quitting your job more so as you are unable to take your 401k loan with you.

Generally, the loan has to be cleared on termination or within sixty days of leaving your job. (Exact timing depends on the rules of your plan.) Failure to clear the loan balance within the specified time period leads to the outstanding balance being considered a distribution and is subject to income taxes and a 10% early withdrawal penalty.

This is very key should you lose your job, or plan to change jobs. Again, to avoid paying taxes, you can roll over the outstanding loan into an IRA before the Federal tax return due date. Also, taxes and penalties won’t accrue as long as the account is being serviced

Finally, please note that under the Tax Cuts and Jobs Act, taxes or penalties are not payable if the balance is cleared by the due date of your tax return for the year when you quit your job (including extensions).

However, as much as this extended time frame will be to your advantage, down the line it will complicate efforts to roll over this 401k balance to a new employer’s plan

Do you have to claim 401k loans on your taxes

401k loans are not to be reported on the federal tax return unless there is a default, as IRS considers thus a “distribution” and subject to early withdrawal rules.

The interest payments made on the 401K loan cannot be treated as a deductible since the loan is considered a personal loan. The loan repayments are simply a refund into the tax-deferred retirement account.

The interest paid on the 401K loan to buy a home is also not deductible, as it’s not considered mortgage interest (the home is not security for the loan) and cannot be claimed as Home Mortgage Interest Deduction. A normal mortgage is a secured debt since you have to put up your home as collateral hence the interests of the lender are protected.

 Do 401k loans show on credit report

 401k loans are not reported to the credit-reporting agencies However, when making an application for a mortgage, lenders do ask you if you have 401k loans and will count it as a debt.

Should you default on your 401k loan, it will not be reported to the credit-reporting agencies and hence will not have any effect on your credit rating. This is so because you are essentially borrowing money from yourself.

401k loans pros and cons

Should I take a 401k loan

The advantages of a 401K loan are as below;

  • Applications for 401K loans can be made with a few clicks on the plan’s website. Funds are usually processed in a few days, and with total privacy. You don’t need to explain your needs or how you intend to spend them.
  • The employee is essentially borrowing from themselves. No minimum credit score will be required and it won’t affect the saver’s credit report in the future.
  • 401K loans Usually do not carry a prepayment penalty
  • 401K loans have comparatively low-interest rates to banks or other lenders, especially for individuals with a low credit score. Although the employees pay back interest on the loan, the funds go back into their 401k account.
  • Its more preferable to withdraw money, as there is no income tax or early withdrawal penalty

The disadvantages of a 401K loan are as below;

  • Borrowing from your 401k means a Loss of potential tax-free investment gains. It also increases the likelihood of stopping current contributions on the plan as payroll deductions reduce take-home pay.
  • The Potential for default is high should you lose your job, resulting in taxes and penalties
  • Some sponsors restrict any further pretax contributions until the loan is fully settled. This derails long-term retirement plans.
  • Your repayments will come from after-tax dollars. Remember this stands to be taxed again when you eventually withdraw them from the retirement account.
  • The interest paid is not tax-deductible regardless of whether the funds were used to renovate your home.
  • The arrangement fees for the 401k loan may be higher than the charges on a conventional loan.

Bottom Line

Only consider a 401k loan if you have exhausted all other financial options, including home-equity loans. To reduce the possibility of having to take a 401k loan try to keep emergency savings. This should at minimum be able to cover 3 to 6 months’ worth of basic living expenses.

A 401k loan should only be an option if your job is secure. The amount borrowed should be able to totally fix a worse problem at hand.

 

 

About George Karl 66 Articles
George Karl, CPA is an expert in Accounting, Corporate Finance, and Personal Finance. George is a holder of a Bachelor's Degree in Accounting from Egerton University. He is currently working as a Chief Financial Officer in an American Owned Investment Bank in Africa. He has over 15 years of experience in finance and taxation.

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