Thinking About Taking a 401(k) Loan? 5 Things to Know First

You need a lot of money quickly. Your bank accounts aren't enough, and you're worried about how much a loan might cost you, or if you'd even be approved. You thought about tapping your traditional IRA, but you don't want to pay the 10% early withdrawal penalty for taking money out before you're 59 1/2.

By process of elimination, a 401(k) loan seems like your best option. You're borrowing money from yourself, so there aren't any credit checks, and you reap the benefits of the interest you pay back over time. It's possible that this is a smart move, but before you make that call, you need to understand the following five things.

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1. Not all plans allow 401(k) loans

Employers don't have to allow you to take 401(k) loans. If your company doesn't permit it, you'll have to explore other ways to get the cash you need. Check with your HR department or your 401(k) plan administrator to learn if your plan allows 401(k) loans.

You typically cannot take a loan from a 401(k) you had through a previous employer, even if that employer allows its active employees to take 401(k) loans. However, if your current employer permits loans, you might be able to roll your old 401(k) over into your current one to access those funds. Again, it's worth checking with your HR department to see what the company allows in terms of rollovers, as some companies won't let you do this.

2. How 401(k) loan repayments work

A 401(k) loan permits you to withdraw up to 50% of your vested account balance or $50,000, whichever is less. If your vested account balance is less than $10,000, then you can withdraw up to $10,000. There are no rules about what you can or can't do with the money, but there are rules governing repayment.

You'll have to pay back the loan with interest within five years. If you aren't able to do this, the IRS will treat the outstanding amount as a distribution, and you'll pay ordinary income taxes on it, plus a 10% early withdrawal penalty if you're under 59 1/2.

Make sure you understand the repayment terms you're agreeing to before you sign up. If you don't think you'll be able to adhere to the repayment schedule, a 401(k) loan probably isn't right for you.

3. You might need your spouse to approve it

If you're married, you may need to get your spouse's permission to take out the 401(k) loan. This isn't required by federal law. Instead, employers choose whether to mandate it. Check with your HR department if you're not sure of your company's policy.

4. What happens when you quit your job?

Since 401(k) loans are typically only for active employees, quitting your job or otherwise separating from your employer can cause you to go into default on the loan if you're not able to pay back the full outstanding balance at that time.

In this scenario, you'll owe income taxes, plus the 10% early withdrawal penalty if you're under 59 1/2. However, this type of default shouldn't affect your credit score,as 401(k) loans typically aren't reported to the credit bureaus.

All the same, if you don't expect to remain with your employer for the next five years, a 401(k) loan may not be the right fit for you. Consider a bank loan, saving up on your own, or even taking a Roth IRA withdrawal. Since you fund Roth IRAs with after-tax dollars, you're allowed to withdraw your contributions tax- and penalty-free at any age.

5. You'll set your retirement savings back

Even if you manage to pay your 401(k) back on schedule, your account value at retirement will likely be less than what it would've been if you hadn't taken the loan out. This means you may have to increase your future contributions if you hope to retire when you originally planned.

This doesn't mean a 401(k) loan is always the wrong choice. If you don't qualify for a bank loan and you have no other way of getting the money you need, it could still be right for you. Just make sure you understand exactly what you're getting into before you sign on the dotted line.

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