If you are currently employed and your 401k plan does not allow for in-service 401k withdrawals then a 401k loan might be a good idea as there are no early withdrawal penalties nor taxes due if the 401k loan is repaid according to plan, and IRS, rules. A 401k loan might also be a good idea of you are self employed and would like to tap your 401k for a loan and pay yourself interest instead of getting a loan (or being rejected) by a financial services institution.
Loans from a 401k plan are an optional plan feature and a typical 401k plan does not need to have a 401k loan option. Plan sponsors can have 401k loans as a feature in their 401k plan. If they do, however, the IRS mandates that the 401k plan adheres to certain rules and regulations for all 401k plans that offer a 401k loan option. Keep in mind that many companies require you to immediately repay your 401k loan balance should your employment with them terminates. Also, keep in mind that if you break any of the rules mandated by the plan, or the IRS below, then your 401k loan is considered to be a 401k distribution with taxes and possibly early withdrawal penalties due.
What are 401k loan rules?
401k loan agreement – the IRS mandates that the 401k loan agreement must be a legally enforceable document in writing that is similar, in form and in competitive terms, to a loan agreement from a financial institution that states the date, interest rate, amount, payment schedule, level payment amount, and duration of the loan.
Maximum amount of a 401k loan – the maximum amount for a 401k loan must be either 50% of the vested balance of a participant’s account or $50,000 – whichever is less. An exception can be made to have a participant take up to $10,000 even if it is more than 50% of their vested balance. If the plan participant previously took out another 401k loan, then the plan sponsor must reduce the $50,000 limit of the new loan by the highest amount owed by the participant on other participant 401k loans during the one-year period ending on the day before the new loan.
Maximum duration of a 401k loan – the IRS mandates that the maximum duration of a 401k plan loan should be no longer than 5 years. There are two exceptions to the 5 year maximum loan duration: 1) if the employee takes out the loan to buy their main home and 2) if the employee is called for military service. In this case loan repayments can be suspended during military service and the 401k loan must be repaid within 5 years PLUS the time taken off for military service.
401k loan repayment schedule – Employees who take out a loan should make at least quarterly level repayments that include both principal repayment and interest during the duration of the loan. Employees who take a leave of absence from work can suspend loan payments for the duration of their leave of absence not to exceed one year. However, this leave of absence cannot extend the duration of the loan beyond the 5 year maximum. After returning from their leave of absence employees must either make extra catch up loan payments or should increase the amount of their payment installments in order to maintain the 5 year maximum 401k loan duration. In the case of military service, employees can suspend payments for more than one year if that time was spent performing military service and the duration of the 401k loan can be extended beyond 5 years to include the time spent performing military service.