Although federal Internal Revenue Service, or IRS, regulations prohibit using a 401(k) plan as collateral for a loan, it is sometimes possible for an individual to obtain a loan directly from the 401(k) account.
Basic Inaccessibility of 401(k) Funds
Generally, 401(k) plans are very popular retirement-saving vehicles, because of their tax-deferred status and the fact some employers offer matching contributions. However, one of their drawbacks is lack of accessibility. The structure of a 401(k) account is different from that of a traditional individual retirement account, or IRA.
While an IRA is held in the name of the account-holder, a 401(k) account is held in the name of an individual’s employer on the individual’s behalf. The specific 401(k) plan offered through the employer governs the circumstances under which individuals can withdraw money from the account, and many employers only allow early withdrawals in the event of a severe financial hardship. This basic structural fact regarding 401(k) accounts is one of the main factors that presents an obstacle to using account funds as collateral for a loan.
One of the other primary problems stems from the fact that these accounts are specifically protected from creditors by the Employee Retirement Income Security Act, or ERISA. Therefore, if a 401(k) was used as collateral for a loan, the creditor would have no means of collecting from the account in the event the borrower defaulted on the loan payments.
Obtaining a Loan From a 401(k)
In lieu of using a 401(k) account as collateral, an individual may be able to borrow the money he needs from the 401(k) account itself. You are only allowed to take a loan from your 401(k) when the initial plan documents that established the employer-sponsored plan explicitly state that a loan provision is included. You can request this information from your company’s human resources contact or your 401(k) plan sponsor.
Once you have determined that a loan against your 401(k) is available, make a loan request for the amount you need up to your available limit directly to your 401(k) plan sponsor. For instance, if your 401(k) plan is managed by Fidelity, direct your request there. Once your plan sponsor processes and approves your 401(k) loan request, you receive a check or direct deposit for the amount requested, minus any loan origination fees.
401(k) Loan Limitations
As of 2018, the IRS allows an individual to borrow whichever is less: up to $50,000 or 50% of the account’s vested value (the amount in an individual’s 401(k) he would receive in the event he left his job); employer contributions may not be included in that total.
While this restriction is the same for nearly all employer-sponsored plans, companies vary on which limitations are placed on the use of loan proceeds. With some 401(k) plans, employees are only allowed to take a loan to pay for medical expenses not covered by insurance or education expenses for a spouse or child. In other cases, they can use loan funds for a down payment on a home purchase or for general financial hardship.
The 50% loan limit may not apply in the event an individual’s vested account value is less than $20,000; in that case, the individual may be allowed to borrow as much as $10,000 from the account provided the vested account value is at least $10,000.
Repayment Terms for 401(k) Loans
Just like other loans, those funds obtained from a 401(k) account must be paid back, plus interest; it goes to the 401(k) account i…