Many employees may not realize that they can take loans from the money that they have saved in their 401(k) plans. While doing so carries some risk, as failing to pay back the money will trigger significant tax penalties, it does provide employees with the ability to quickly borrow money interest free regardless of their credit score.
401(k) owners are allowed to borrow up to 50% of the vested balance in their 401(k). The vested balance is the amount of money in the 401(k) that an employee would have access to if he or she were to leave the company immediately. Many companies require employees to fulfill certain conditions, like working for a certain amount of time, before they will be entitled to receive all of the money that the company has set aside for them. The maximum amount of money that can be borrowed in a 401(k) loan is $50,000.
401(k) owners who take a loan have five years to repay it. Payments must be made at least quarterly. Owners actually have to pay interest on the loan (which is about 2 points higher than the prime rate), but since this interest goes back into the owner’s 401(k) account the owner is not actually losing any money. The loan must be paid back with money that has already been taxed, and the money paid is not considered a contribution to the plan.
If an employee fails to repay a loan taken from his or her 401(k) account, then it becomes a 401(k) distribution. This means that the employee will have to pay income tax on the distribution plus an additional 10% early withdrawal penalty. Depending on the employee’s tax rate, this could mean that he or she will be required to pay a tax bill of 35% to 45% of the loan amount. Also, if an employee switches jobs or the 401(k) program ends, then the employee has just 60 days to repay the loan or suffer the 10% penalty in addition to paying income tax.
Other downsides from 401(k) loans are potentially origination, administration, and maintenance fees for the loans. Also, money taken out for a loan will not be available for market appreciation.
Most employers hire companies to run their 401(k) plans, and they will handle the details of an employee’s withdrawals from a 401(k) policy. I would suggest contacting this company if you have specific questions about how 401(k) withdrawals work.