Loans are not available in all 401k plans but most 401k plans do permit participants to borrow from their plan. Your Summary Plan Description (SPD) will indicate whether your 401k plan has a loan feature. A 401k loan is not taxable if it meets IRS criteria, including the following:
- Loan Amount – up to 50% of the vested account balance up to a maximum of $50,000. If the participant already had an outstanding loan from the plan (or any other plan of the employer or related employer) during the 1-year period ending the day before the loan, the loan maximum is reduced. The amount of the reduction is the participant’s highest outstanding loan balance during that period minus the outstanding balance on the date of the new loan.
- Loan Term – 401k loans must be repaid within 5 years, unless the loan is used to buy the participant’s main home
- Loan Repayments – 401k loan repayments must be made in substantially level payments, at least quarterly, over the life of the loan.
- Interest Rate – the IRS only requires that the interest rate on the loan be reasonable; the plan sponsor sets specific interest rate policy.
Additionally, the plan sponsor has authority to put in place other rules regarding such things as the loan interest rate, the number of loans a participant can have outstanding and allowable uses for loan proceeds.
- Loan Uses – the government does not restrict the purposes 401k loan proceeds can be used for – but employers sometimes do.
- Interest Rate – most 401k plans use the prime interest rate index plus some margin (1 or 2 points) for the loan interest rate. It is important to realize that your true cost for the loan will be the foregone earnings on your 401k while you have the funds out. The interest you pay as part of your loan repayments are actually additional contributions to your 401k.
- Loan Minimum – most 401k plan administrators will have a minimum loan threshold (e.g. $1,000).
- Service and origination fees – some administrators may impose servicing fees to offset their cost of administering the 401k loan.
- Payment Frequency – most plans deduct 401k loan repayments from your regular paycheck.
Bottomline: The rules regarding 401k loans vary widely from plan to plan. Internet resources such as this one can help you with the general rules for 401k loans, but it is critical to know and understand the detailed rules governing your specific 401k plan before taking out a loan. Contact your plan administrator for this information.