Borrowing from your 401(k) plan can be a fast, advantageous way to meet serious financial needs - here's everything you need to know about 401(k) loans

• Borrowing from a 401(k) means withdrawing funds from your plan that you later repay with interest.
• A 401(k) loan avoids the taxes and penalties that come with outright withdrawals.
• Borrowing from a 401(k) has drawbacks, like the suspension of contributions and overall loss of account growth.

Any financial expert will tell you it's best to keep your retirement savings tucked away until, well, retirement. That certainly holds true for one of the most common ways to save for those post-career years: employer-sponsored 401(k) plans.

But life can get in the way of the best investment plans. And if you have an immediate need for cash, borrowing from your 401(k) may make the most financial sense. Especially when you compare that option to other loan alternatives - or withdrawing money entirely from the plan.

However, there are many rules, both from the IRS and individual employer plans, that apply to 401(k) loans. If those are not followed, you may end up paying taxes and penalties that can seriously hamper your finances.

Understanding exactly what's entailed in borrowing from a 401(k) is key to determining if the strategy will suit you. Let's take a closer look.

What is a 401(k) loan?

In a 401(k) retirement plan, you make regular pre-tax contributions and the money grows tax-free. In return for those tax advantages, you must follow several IRS rules, chief among them, no withdrawals without penalties until age 59½. If you do withdraw early, you'll be subject to a mandatory 20% federal tax withholding and in most cases a 10% tax penalty.

Fast fact: In some situations, such as a disability or splitting up accounts in a divorce, early withdrawals won't be subject to the penalty. The IRS also allows for penalty-free hardship withdrawals when the money goes to certain expenses such as medical costs, eviction, college tuition, or the purchase of a primary residence.

A 401(k) loan is basically a way you can take money from your own account without paying these taxes or penalties. You don't get charged, because this is only a temporary withdrawal: You will be putting the money back, eventually. And you won't be depleting your retirement savings permanently.

You will pay interest on the sum you take out, but this money goes back into the plan account. So, in effect, you are both the borrower and lender of a 401(k) loan.

IRS regulations govern 401(k) plans overall, but there is also some flexibility for employers to impose their own rules and restrictions. Most employers that provide 401(k)s plans allow 401(k) loans, says Gregg Levinson, senior consultant at Willis Towers Watson. He estimates that about a third of 401(k)(k) participants borrow from their accounts at some point (not counting the COVID-19 pandemic year of 2020).

Will my employer know if I take a 401(k) loan?

Your employer has to be informed if you plan to borrow from your 401(k) loan - the withdrawal and repayment process is set up through them. This is not to say that the whole company or your immediate boss will necessarily know. Only, perhaps, the payroll department.

How to borrow from a 401(k)

Your first step when considering borrowing from your 401(k) is to contact your employer benefits department or your 401(k) plan provider to get details on how your plan's loans work (assuming, of course, they're offered in the first place).

Here's what to look for in 401(k) loan rules:

• Borrowing limits. The IRS mandates that you may borrow no more than 50% of your account value or $50,000, whichever is less. Some employers and plans will also impose a minimum loan amount, say, no less than $1,000.
• Interest. Your interest rate is determined by your employer but must be "reasonable" and similar to the rate you'd find at a financial institution, according to IRS rules. In most cases employers charge prime plus one percentage point.
• Repayment. IRS rules call for full repayment of your 401(k) loan, with interest, within five years in equal payments that include principal and interest paid at least every quarter. Your own plan may follow those terms, or impose more stringent ones. Many employers use payroll deductions for repayments. Your employer may also allow for longer repayment limits, as recommended by the IRS, if you use the loan for a primary home purchase - sometimes as long as 25 years.
• Number of loans allowed. How many loans can you take from your 401(k) plan? Again, that depends on your employer. Most of them only allow for one at a time; you have to fully repay one sum before they'll allow you to borrow again. So weigh carefully how much you'll need. The IRS itself permits simultaneous loans, as long as the combined amount doesn't exceed the general limits.

Financial update: Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act employees were allowed to borrow up to $100,000 from their 401(k)s and take an extra year to pay back the borrowed money. These increases applied only to loans made in 2020 and have not been included in additional coronavirus relief legislation. "Interestingly, we didn't see a lot of employees taking advantage of that benefit," notes Gregg Levinson, senior consultant at Willis Towers Watson. "That may be why it wasn't renewed."

As long as you adhere to the mandates, all should go well. But if you don't, your loan could be considered a withdrawal, and tax payments and penalties will follow.

Is it smart to borrow from a 401(k) plan?

Compared to other financing methods, borrowing from a 401(k) plan has its advantages. On the plus side, a 401(k) loan offers:

• No need for approval. It's your money, so you're getting it is automatic. No loan applications or credit checks. And borrowed 401(k) funds do not show up on your credit report as a debt.
• Quick access to funds. Often, you can get the money within two weeks.
• Interest rates that are often lower than those charged by credit cards and many personal loans offered by banks.
• Benefits from the interest. You're paying yourself to borrow, instead of a lender. Because it goes into the account, the interest is sort of a boon, not just an expense.
• No prepayment penalty. Unlike some consumer loans, most plans don't charge a fee for loans repaid in full early.

What are the downsides of borrowing from a 401(k)?

401(k)s loans have their drawbacks, too. Downsides include:

• Loss of tax-deferred earnings. Taking money out of your account shrinks it, obviously, and also its earning potential - especially if you take the full five years to repay the loan. The overall effect on your retirement savings will depend on how much you borrow, how long you take to pay it back, and the state of the stock market. Some plans don't allow you to make new 401(k) contributions until the loan is repaid, further hampering the compounding ability of retirement savings.
• Double taxation. Loan repayments and interest are made with after-tax dollars, in contrast to the dollars used for contributions. But they're not distinguished within the account; everything goes back into the same pre-tax pot. So, when you eventually start taking regular distributions from your plan, you'll pay income tax on that money; in effect, you're being double-taxed on the interest.
• Sudden repayment. In most cases, if you leave your employer for any reason you will need to fully repay the loan usually within one to six months, depending on the plan rules and the date of your last payment. If you don't, your former employer and the IRS will consider the loan a distribution. You'll then owe income taxes on the amount and, if you are under age 59½, a 10% penalty. (For Roth 401(k)s, you likely won't owe taxes but you will be on the hook for the 10% penalty.)

"People often underestimate how long they will be with an employer and find themselves in the position of having to come up with the full amount outstanding on the loan or face a large tax bill and penalties," says Levinson.

The financial takeaway

Most financial experts agree taking a 401(k) loan should be a last resort. Employees of a certain age, who are beyond the penalty-incurring years, might find that taking a distribution might actually work better for them.

Still, borrowing from your 401(k) plan can be an option if you need funds quickly. It's certainly a better course than an outright withdrawal, especially if you're under 59½, which incurs penalties as well as taxes.

Before you jump to borrow from your 401(k), it's important to consider the pros and cons. Understanding how 401(k) loans work, the consequences of leaving your employer or losing your job before repayment and the opportunity risks involved in tapping your retirement savings early are all key considerations.

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