A 401(k) can be a useful tool to ensure you have access to plenty of funds during your retirement years. These are employer-sponsored accounts, and, as an employee, you can choose to invest in your 401(k) with funds from your paycheck. In some cases, the employer will match your contributions to the account.
Accounts like this are great job benefits, but keep in mind that the funds are intended for retirement use. Withdrawing funds before you’re over the age of 59 tends to come with consequences, such as a 10 percent penalty. Of course, exceptions do exist, particularly for individuals dealing with disabilities or other medical issues.
In addition to retirement security, a 401(k) can give you access to another tool that can help you out of financial hardships: a 401(k) loan.
How Does a 401(k) Loan Work?
Taking out a 401(k) loan is a little different than taking out other kinds of loans. The first difference to note is that, because the 401(k) contains your personal retirement savings, you’re borrowing money from yourself. The lack of an actual lender means that you won’t be subjected to a credit history check. That’s a significant benefit for people with a low credit score.
Don’t be misled though. Just because you avoid dealing with a lender doesn’t mean you are free of terms and conditions.
You have to repay the money to the account in such a way that makes up for the transaction. In other words, you’ll need to cover for the loss of the gains due to the withdrawal. This is the loan’s interest. The interest is often less than what you’d have to pay when dealing with a bank loan.
The 401k Loan Repayment Rules
The 401k loan repayment rules will vary based on your employer, but you typically have five years to pay back the loan. You won’t have to worry about an early repayment penalty though. You will also have the option to pay back the account via payroll deductions.
How To Get a 401(k) Loan?
Wondering how to get a 401(k) loan from your specific account? You’ll need to review your plan description and talk to the provider to determine the exact process. But before you do that, familiarize yourself with the possible risks.
Risks & Limits Associated With a 401(k) Loan
These loans require no credit check, feature potentially low-interest rates, and mostly require you to shift around money that already belongs to you. Despite all of these benefits, 401(k) loans do come with certain limitations and risks.
As previously stated, there is a repayment period. If you fail to pay yourself back within that time period, you’ll be subjected to the standard 10 percent penalty for withdrawing your retirement funds too early. You’ll also have to pay taxes on the unpaid amount. A default won’t affect your credit score though, as most employers don’t report this kind of information to Credit Bureaus.
If you quit your current employer, the repayment period for your outstanding 401(k) loan will likely shorten.
In addition to the repayment period, there’s a limit to how much you can even withdraw in the first place. A small percentage of employers don’t allow employees to take out 401(k) loans at all. Others set a loan limit of either $50,000 or half of your vested account balance.
Because these accounts link to specific employers, your current job situation can impact the loan limitations. For example, you can’t use a 401(k) account from a previous employer. However, you can access those funds if you’ve rolled them into your new 401(k).
When to Use a 401(k) Loan
As in the case with other loans, you shouldn’t borrow money from your 401(k) unless you really need it. Here are a few reasons to consider borrowing from your account:
- You owe on back taxes and struggling with the penalties and interest.
- You’re at risk of defaulting on your student loan – bankruptcy isn’t a way out of student loan debt.
- You’re on the brink of eviction.
- You’re generally struggling with high-interest debts.
Note that most of these problems have multiple solutions that don’t involve pulling from your own retirement funds. For example, the IRS offers tax relief programs for certain individuals.
Сonsider Your Financial Difficulties
It’s also vital that you address the factors that led to your financial hardships in the first place. You don’t want to find yourself in a situation where you’re continually borrowing money that’s meant to keep you secure later in life.