The primary benefit of 401k loans is that the proceeds are not subject to taxes or the ten-percent penalty fee except in the event of default. The government does not set guidelines or restrictions on the uses for 401k loans. Many employers, however, do; these can include minimum loan balances (usually $1,000) and the number of loans outstanding at any time in order to reduce administrative costs.

Additionally, some employers require that married employees get the consent of their spouse before taking out a loan, the theory being that both are affected by the decision.

401k Loan Limits

In most cases, an employee can borrow up to fifty-percent of their vested account balance up to a maximum of $50,000. If the employee has taken out a 401k loan in the previous twelve months, they will only be able to borrow fifty-percent of their vested account balance up to $50,000, less the outstanding balance on the previous loan. The 401k loan must be paid back over the subsequent five years with the exception of home purchases, which are eligible for a longer time horizon.

401k Loan Interest Expense

Even though you?re borrowing from yourself, you still have to pay interest! Most plans set the standard interest rate at prime plus an additional one or two percent. The benefit is two-fold: 1.) unlike interest paid to a bank, you will eventually get this money back in the form of qualified disbursements at or near retirement, and 2.) the interest you pay back into your 401k plan is tax-sheltered.

The Drawbacks of 401k Loans

The biggest danger of taking out a 401k loan is that it will disrupt the dollar cost averaging process. This has the potential to significantly lower long-term results. Another consideration is employment stability; if an employee quits or is terminated, the 401k loan must be repaid in full, normally within sixty days. Should the plan participant fail to meet the deadline, a default would be declared and penalty-fees and taxes assessed.