What are the things you need to know before taking out a 401(k) loan?

Q. I am currently in a tight financial situation. The company I have worked in for over ten years offers a 401(k) plan to its employees. I was thinking of taking out some amount from my 401(k) account as a loan. However, I have heard that this may not always be the best option. I wanted to know more about how a 401(k) loan works, and any other thing that will be of help. Scott, Wisconsin

Hi Scott, while you may be tempted to take out a 401(k) loan, it is true that it may not always be the best option since failure to repay will have serious consequences. Consider it your last resort if you have no other options. Many people think that since you are borrowing your own money, it is a simple process. But the truth is that taking out a 401(k) loan is not as simple as it sounds.

If you still think that borrowing from your 401(k) plan is the way to go, then there are some things to keep in mind. The first thing you have to check is how much you can borrow. Usually, the limit is set to 50 percent of your retirement plan or $50,000 – whichever is the lesser amount.

When borrowing from your 401(k) plan, you don’t have to go through a credit check since you are taking out your own money; no financial institution is loaning you the money.

However, even though you do not have to run a credit check, you still have to pay the interest. The interest rate depends upon your loan plan, which is usually based on the current industry rates. Apart from this, taking out a 401(k) loan will also require you to follow a strict repayment schedule. This means that you have to pay back your loan, along with interest, within five years. However, if you use the loan to buy a home, the period for repayment is usually more than ten years.

Lastly, make sure that you do not miss any of your payments. Failure to repay your 401(k) loan on time will have some serious repercussions. If you miss a payment, your employer will regard it as you withdrawing from your 401(k) plan. This means that not only will you have to pay taxes on the loan you take out but also pay the penalty for withdrawing from your retirement plan early.

Borrowing Against Your 401k Plan

I own and operate a small business that sells solar powered systems for residential applications. I have heard that the IRS allows you to borrow against your 401k plan, but not sure how it works. Can you throw some light on this matter? Darryl Allinder, Albuquerque

Yes, one of the advantages of a 401k plan is that the IRS permits you to borrow against it, but keep in mind that the loan option is not offered with all plans. Also, the maximum amount that you can borrow with your 401k plan is 50% of the 401K account balance or the lesser of $50,000. This is required to be paid over a term of five years. The rate of interest is determined by your 401k plan and is typically just a couple of points over the prime rate.

Borrowing against your 401k is a relatively easy process. Verify if the rules of your 401k plan permit loans or get in touch with the administrator of your plan for more details regarding the same. Your plan may disallow you from borrowing or limit the loan use for certain purposes like medical expenses only. If you have a 401k management package from http://smallbusiness401k.com/, you can exclude or include 410k loans, based on your requirements and preference.

To initiate the 401k loan process you will have to fill in a request form, and provide information such as you name, account specifics, Social Security Number, and other details pertaining to the loan. There is no credit check for a 401k loan approval. Also, there aren’t any tax implications when you borrow against your 401k. Once the loan is sanctioned, you have to repay it along with the interest over the 5-year term with loan payments on at least a quarterly basis. This money will be deposited back into your 401K account.