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.

Taking Loans from a Solo 401k

I run my own florist’s shop where the only employee is my wife. Can I set up a Solo 401k plan for my business that I can take a loan from in future? I do hire some help occasionally but have no other full time employees as of now.- Herman F. Stout, Pullman, WA 99163 

Businesses like yours that do not employ full time employees can set up a Solo 401k or Self Employed 401k, as it is also called. The fact that your wife is a full time employee does not prevent you from opening this retirement benefit plan. To all intents and purposes, the IRS considers your wife as a partner in your business rather than an actual employee.

You can take a loan from this account at a future date if you have a financial emergency. There are some stipulations and restrictions regarding taking loans in this way. A most important one is that you have to limit your loan to half of your account balance in the 401k account. Plus, the total loan should not exceed $50,000. When you repay the loan, the money goes back into the account and so does any interest you pay on the loan. In effect, through the Solo 401k loan you give yourself a loan and pay yourself back too.

Making sure that you do repay on time is very critical because you would end up paying penalties otherwise. If you fail to follow the loan repayment terms you may even end up paying tax on the amount you have withdrawn. A good way to keep track of your loan is to use a DIY 401k suite like http://runityourself401k.com/. With this software package it is an easy task to view your account status, get monthly statements as well as manage the account by just investing a few minutes of your time every month.