Understanding 401(k) Loan Repayment Terms
Borrowing from your 401(k) may seem convenient when you need funds for whatever reason. However, like any loan, a 401(k) loan comes with its own repayment terms and conditions, which need to be understood thoroughly before making a decision.
Essentially, a 401(k) loan permits you to borrow from your retirement savings. Tax law allows employees to borrow up to 50% of their 401(k) funds or $50,000 (whichever is less). If you have $20,000 or less in your plan, you can borrow up to $10,000, limited by how much you have in the plan. See the IRS website for more detailed examples of what may be permitted.
For some, this is appealing as it provides access to a low-interest loan in the form of a lump sum without the same credit-check processes you would undergo with a typical lender.
However, the money is not free; the repayment typically involves a defined payback schedule with interest rates and payment due dates, often managed via payroll deductions.
But be careful. Defaulting on a 401(k) loan can lead to severe financial repercussions, impacting your long-term financial health. Typically, if you leave a job, you might have to make your loan repayment within a short period of time. If you don’t make that deadline, you may face what’s called a “deemed distribution”, and owe penalties and income tax on the withdrawal.
For instance, the unpaid portion of your loan may be deemed a taxable distribution by the IRS, which means it’s subject to income tax and could incur additional tax penalties if you’re under 59.5. Under the Tax Cuts and Jobs Act, borrowers can repay their loan amount into an IRA to avoid generating taxable income from their retirement account loan.
Tax consequences are not the only risks to consider. Your retirement savings will also suffer from taking a loan, as those funds won’t benefit from compound growth when they aren’t in the account. You also may be subject to an early withdrawal penalty of 10%.
4 Ways To Repay A 401(k) Loan
Repaying a 401(k) loan to your former employer may feel like an overwhelming task, but with the right strategy, you can replenish your plan loan, make loan payments ahead of the due date, and shorten your repayment period to reduce interest charges.
Let’s look at several approaches that can be tailored to suit your financial situation.
1. Pay Off the Loan in Full
The most straightforward option is to pay off the loan in full, although it’s understandable that this may not be an option. If you have the funds, this is a smart decision to avoid having the loan count as a taxable distribution on your federal tax return (if you were to default on the loan in the future).
2. Increase Contributions to Your New Employer’s Plan
If your new employer offers a 401(k) plan, one approach is to contribute a higher percentage of your paycheck to help offset some of the outstanding loan balance. However, remember that there will be an upper limit on contributions, and different plan administrators may have varying policies.
3. Use a Balance Transfer Credit Card
This strategy involves moving your 401(k) loan to a credit card, potentially with a lower interest rate. However, this option needs careful consideration, as high-interest rates may apply after the introductory period, and credit card debt can be even more detrimental to your personal finances.
Remember that interest on a 401(k) loan is paid back into your plan account balance, so all is not lost from paying a bit of interest. But you’ll need to come up with the cash either way, and interest paid to your 401(k) plan isn’t the most tax-efficient.
4. Obtain a Personal Loan
In some situations, you may be able to secure a personal loan with more favorable terms than your 401(k) loan, especially depending on your credit score and the loan amount.
Again, interest to a personal lender will be considered a pure expense, while interest on a 401(k) loan is somewhat like additional savings.