How Does A 401k Loan Work?

If you are like most people with any sort of savings, most of our money tends to be invested in illiquid retirement accounts.  Although it is wise to be planning and investing for retirement... a person should always have a stockpile of emergency savings to use in case of just that...an emergency.  But sometimes life gets in the way, and a person will need to access their 401k retirement savings.  So how does a person do that? 

Lucky for you, most employers have implemented 401k's with a loan provision(its not required of the employer) where a 401k participant is able to loan money to themselves.  You might be thinking, "why would I loan money to myself?"  The reason that it is taken in the form of a loan, is so that the participant can avoid what the IRS would call a "taxable event."  That is what would happen if you simply removed money from your 401k(before retirement) without implementing a loan.  It would be a taxable event because often times, money contributed to a 401k is contributed before tax.  At the very least, you would likely incur a penalty for removing money from your 401k before the retirement date set by the IRS. 

How Do I Take Out A 401k Loan?

The first step is to sit down with your employer or an HR director and determine the terms of your 401k loan.  After speaking with them, and based on procedural documents laid out beforehand(either by the company or the IRS) they will inform you of your interest rate, the amount of your loan payment, the time over which the loan will be repaid, and the amount of money you qualify to take in the form of a loan.

A question you might be asking at this point is, "I have to pay interest on money I'm loaning to myself!?!"  That is correct, you have to pay interest on the loan.  However, unlike a loan from the bank or a mortgage, the interest that you pay, will return directly to your 401k account.  So really, you are only paying interest to yourself.  In addition, the interest rate on a 401k loan from yourself, generally speaking, is very low relative to other interest rates in the market.  

Caveats To Be Aware Of When Taking A 401k Loan

1. The maximum loan length is 5 years.  This means your loan payments will be relatively large when paying back the loan in such a short time.
2. The portion of your 401k that is the loan, will cease to be invested inside of your 401k, potentially causing you to miss out on growth inside your 401k. 
3. If while you have an outstanding 401k loan, you get fired or laid off, you may incur a taxable event.  Speak with your HR representative on how you can avoid this as this can be very expensive.
4. Your 401k loan repayments will likely come straight out of your paycheck.  If your monthly budget is tight, then you'll have to find a way to squeeze a little more out of your budget after taking a 401k loan.  If you can't find room in your budget to pay the loan back, this isn't a good idea.

What Are (Possible) Good Reasons To Take A 401k Loan?

There's really only three good reasons to ever take out a 401k loan. 

1. First, and one we've already mentioned....is to help bridge the gap in the event of a financial emergency.  It will be up to you what defines an emergency, but taking money out of a 401k should be taken very seriously with much trepidation.  
2. Second, if you have somewhere else you want to invest the money.  Again, this should be approached with caution and the goal should be that the alternative investment should provide a greater potential rate of return than your 401k with less risk.  If it doesn't, don't even think about it.
3. Third, sometimes it makes sense to take a 401k loan to make a larger down payment on your home, thus reducing the mortgage.  By increasing the down payment, you will hopefully have to pay a smaller rate of interest to your 401k, and less to the bank.  Secondly, it may make sense in order to avoid paying PMI(private mortgage inurance) fees thus lowering your mortgage APR.  

Can I Borrow From An Old 401k? 

No, it is not allowed to borrow from an old 401k as only your current employer can administer a 401k loan program.  It is possible for you to transfer funds from an old 401k into your current 401k...at which point you would be able to use it to take a 401k loan.  Of course, this is contingent upon your current employer allowing 401k loans to be taken.  

Conversely, if you rolled over your old 401k to an IRA, you are not able to borrow from an IRA.  

Conclusion

A 401k should first and foremost be for retirement.  There are instances however, when its potentially a good idea to take money out of your 401k in the form of a loan.  It will require discipline and perseverance to pay the 401k loan back, and it should be the highest goal, as failure to pay back a 401k loan can make a bad situation worse.  But if you do have financial discipline, a 401k loan can be just another tool in your toolbelt to help you achieve your financial goals. Be sure to check out our 401k loan calculator that allows you to calculate your loan payment, as well as compare an alternative investment side by side with your 401k.