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How 401(k) Loans Work
Let's take a moment to review your 401(k) loan and understand how it works. While there may be some differences depending on the institution, the basic structure is generally the same across the board.
- Minimum Withdrawal – Typically, when you take out a 401(k) loan, there will be a minimum withdrawal amount. This could be as low as $500 or as high as $1,000, but from there, you can withdraw a larger balance, depending on how much is available in your 401(k) account.
- Maximum Withdrawal – You’re not able to completely bankrupt your 401k account either. You can take out up to 50% of what’s considered the vested amount in the account. But you can’t always take that much either. If you have more than $100,000 vested in your account you still won’t be able to take out more than $50,000.
- Strict Terms – When you do take out that loan you’re going to have to have a plan for paying it back. That’s because you’re only given a total of 5 years to pay back the loan. Luckily, you’re also getting a prime rate plus 1%, so while it’s not the best interest rate you could get, it’s not too bad either.
- Fees Charged – You will need to pay fees just for the benefit of getting that loan and the fees could be anything from $50 to $100 or more.
It’s important that you know all of these things before you take out a 401k loan because you don’t want to find yourself in even more financial trouble than you were before. Your loan may not be the best way to go.
401k Loan Taxes
Now, the benefit of this type of loan is that you don’t have to pay taxes when you first take it out. But if you don’t manage to pay back everything, including all of the fees, before the time limit on your loan runs out you’re going to have all kinds of taxes. And you’re going to have all kinds of penalties too.
Even more, if you leave the job that provides that 401k you only get 60 days to pay back everything, no matter how long you had left on the loan.
Not paying your loan back properly or on time means that it’s legally considered a ‘distribution.’ A distribution is going to be taxable income and, for those who aren’t at least 59 ½, it also becomes a penalty. That means you have to pay an additional 10% on the loan as a withdrawal tax.
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How 403(b) Loans Work
Now, once you reach the age of 59 ½ you’re going to have the ability to take money out of your 403b whenever you want and for any purpose that you want.
That’s when you’re no longer going to be subject to any kind of early withdrawal penalty, but you’re going to have to pay income taxes because it’s considered a distribution at that point.
Now, for those who are under that age limit it can actually be difficult to get a withdrawal at all. At least, if you work for the same company that provides the 403b it can be.
Your employer needs to offer what’s called hardship distribution otherwise you can’t take the money out. And that hardship distribution is only available if you can’t get a loan any other way. That makes them somewhat difficult to get.
403b Loan Taxes
Keep in mind that a hardship distribution doesn’t mean you’re off the hook for taxes. You’ll still need to pay them, and you’ll also face an early withdrawal penalty.
So, even if you're in a tough spot or using the funds to buy your first home, you'll end up with a significant amount in fees and penalties when you take out that money.
