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A 401(k) loan allows you to borrow funds directly from your retirement savings, which you then repay with interest back to your own account. While this can seem appealing since you’re essentially paying interest to yourself, strict 401(k) payback rules must be followed to maintain compliance. Given the complexities and potential long-term impact on your retirement savings, working with a financial advisor can help you determine if a 401(k) loan aligns with your financial goals.
A 401(k) loan allows participants of an employer-sponsored retirement plan to borrow against their own retirement savings. Unlike traditional loans, no credit check or lengthy application process is typically involved. Borrowers can generally access up to the greater of $10,000 or 50% of their vested account balance or a maximum of $50,000, whichever is less.
The loan is repaid directly into your 401(k) account, usually through automatic payroll deductions. Interest charged on the loan is credited back into your retirement savings, making it different from conventional loans where interest is paid to a third-party lender. However, this also means the borrowed amount is not invested during the repayment period, which is typically five years.
It’s important to confirm specific details with your plan provider because there are varying rules for loan amounts, repayment schedules and interest rates.
Knowing your 401(k) payback rules will help you avoid penalties, protect your retirement savings and comply with IRS guidelines when repaying a loan. Here are four key things to consider.
Most 401(k) loans must be repaid within five years, with the notable exception being loans used to purchase your primary residence. Payments are typically made quarterly, but can be more frequent, with many plans requiring automatic payroll deductions. Failing to adhere to the specified repayment schedule may result in the loan being classified as a distribution, subjecting it to income tax and potentially early withdrawal penalties.
The interest rate on a 401(k) loan is generally set at the prime rate plus 1% or 2% and is deposited back into your 401(k) account. While this benefits your retirement savings, keep in mind that the amount borrowed can impact your retirement nest egg as missed investment earnings, too. Some plans may also charge origination fees or ongoing administrative fees for managing the loan.