People often wonder if they can borrow money from their 401(k) plans. The answer is yes, but there are a number of things to bear in mind when you do.
Firstly, the money that was paid into your 401(k) is your money, but it was allowed to accrue interest tax-free. In addition, money that you paid into the fund was tax-deductible. In order to enjoy that tax-deferred or tax-free status, you have to comply with specific IRS regulations.
When you take out a car loan, what happens when you don’t pay it back? They come and they repossess the car, of course.
Now, what happens if you default on a loan from your 401(k)?
The IRS will consider the 401(k) “distributed”. That means they assume you cashed out your account. Not only is the entire fund now voided, but you face a 10% penalty for cashing out early. You may also be forced to pay an additional capital gains tax.
Guidelines for Executing a Loan with Your 401(k)
401(k)s are not like savings accounts where you simply withdraw money and pay it back whenever. You must draw up a legally executable contract and that contract must follow IRS guidelines. The repayment plan must also conform to IRS guidelines. In other words, it’s risky to borrow against your 401(k), but it can be done, and safely.
401(k) Loan Limits
No loan taken from a 401(k) is allowed to exceed either $50,000 or half the vested balance, whichever is lower.
401(k) Loan Repayment Limits
The loan must be repaid over a period of no more than 5 years. Exceptions are made for loans used to purchase homes.
401(k) Loan Repayments and Interest
You can’t just float yourself an interest-free loan. The loan must be repaid on (at least) a quarterly basis with a legitimate interest rate attached to it. The loan must be 1% over prime and there must be an agreed upon amortization schedule.
Section 72(p) regulations are not meant to hurt you. They’re meant to help you. When you borrow against your 401(k) you are using tax-exempt monies that the IRS and the government have allowed you to set aside for your retirement. If you could just take money out of the fund then that would defeat the entire purpose of it.
Logistically, you’re borrowing the money from yourself and then paying it back with interest. Technically, however, you are borrowing money from a fund that enjoys tax-free or tax-deferred status. There are conditions for enjoying those exemptions.
Our recommendation is to tread lightly and know what you’re getting into before executing the loan. If necessary, have someone help you with the process.