A 401K loan is literally a loan borrowed from a 401K retirement plan. Since 401K’s are managed retirement plans, and regulated by the U.S. Department of Labor, the policies implemented by 401K managers tend not to vary excessively. To obtain and retain a 401K loan, one should be employed, have an existing 401K with more than $1000.00 and remain employed at the organization for which the loan is managed until the loan is paid off.
Application for a 401k loan
Obtaining a 401K loan is easier than obtaining home equity loans because the money is not coming from a bank but rather from liquid personal assets. The application process is fairly easy and shouldn’t involve a credit check, supporting loan application documents and lengthy loan application review. Essentially the process of obtaining a 401K loan can take place in 4 easy steps.
1. Contact employer department responsible for 401K registrations
2. Ask about 401K borrowing terms and agreements
3. Apply either online or through the 401K management firm
4. Receive funds either via check or electronic transfer
In the case of 401K managers who do not allow 401K loans, there is a regulation that allows loans to be taken against the retirement plan under circumstances of need. Since specific criteria are needed for these hardship loans, they may involve extra documentation to verify the loans are in fact needed and cannot be obtained elsewhere. The hardship need may or may not be difficult to prove to the 401K manager. (about.com)
401k loan terms
As with many loans, 401K loans have specific terms of agreement as determined by regulation and 401K manager’s policy regarding the loans and in accordance with regulations pertaining to 401K loans. Many 401K loan terms are standardized and include similar features such as those listed below. The website www.research401k.com and other 401K related sites illustrate the terms of these loans, some of which are listed below.
• Loans must be repaid before distributions can be made
• Up to 5 years to repay the loan without pre-payment penalty
• Interest payments made to self
• Up to 50% of account value can be borrowed
• Loan payments deducted from employer pay (after payroll tax)
• $1000-$50,000 borrowing limits
• No distribution tax on loan funds received if paid prior to end of 5th year
Many financial advisors and much financial literature advise against the use of 401K loans because of the duplicated losses incurred by the loans. More specifically, interest and/or appreciation is lost in the 401K itself, and the difference between pre-tax and after-tax income is lost when repaying the loan (moneycentral.com). In other words, since 401K deposits are made with pre-tax earnings, this lowers one’s taxable income and increases one’s income leverage. When after tax income is used to pay off the 401K loan, income leverage is reduced. Additionally, retirement plans are generally best left untouched as the habit of borrowing from one’s retirement can become costly if repeated and relied upon.
That said, 401K’s are a quick source of financing for emergencies that don’t require as much procedure as a home equity loan. The interest is usually around half to two thirds lower than a credit card and when you pay the loan back you’re paying yourself and regain some of the appreciation lost from the 401K loan. (forbes.com) 401K loans are useful as an alternative source of financing
Summary
401K loans are made against one’s employee retirement savings plan known as a 401K. These loans are simply acquired through the 401K administrator if their policy allows such loans against the 401K plan. 401K loans are a quick source of capital at an interest rate lower than credit cards, title loans and collateralized loans because 1) interest on the loan is returned to the 401K and 2) the interest rate on 401K’s does not far exceed the prime rate which is a key lending rate charged by banks.
401K loans may not be an offered service from all 401K administrators so it is important to understand the terms of the retirement plan in the case of anticipated and non-anticipated future 401K loan needs. The amount of 401K loans are capped at $50, 000.00 and do not have penalty or direct cost other than lost pre-tax income leverage and 401K appreciation. 401K loans may consequently be relatively cost effective financing and useful up until a point after which alternate source of financing may be required.
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Sources:
1.http://invest-faq.com/cbc/ret-plan-401k.html
2.http://www.research401k.com/401k-loans.html
3.http://moneycentral.msn.com/articles/retire/basics/4714.asp
4.http://www.forbes.com/2008/09/02/401k-loan-borrowing-pf-education-in_rw_0902investopedia_inl.html
5.http://beginnersinvest.about.com/od/401k/a/aa122104a_3.htm