How to Borrow Money Using a 401k as Collateral
The Internal Revenue Service (IRS) allows retirement plan administrators to offer 401k loans, using the account as collateral. Plan participants can borrow up to 50 percent of the total account value. For example, if the account value is $20,000, you can borrow up to $10,000. However, loans can't exceed $50,000. If you're interested in using a 401k plan as collateral to borrow funds, it's important to understand the process.
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Instructions
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Contact your plan administrator to learn about the company's programs and determine if it offers this loan program. Not all plan administrators offer 401k loans.
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Request a loan application. Complete and return the application to the plan administrator for processing and approval. Some administrators allow plan participants to complete all paperwork online. Ask your administrator if the company offers this option.
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Select a loan term. The IRS allows plan administrators to offer loan terms of up to five years in most situations. However, if you are borrowing to purchase a home, the loan term can extend up to 30 years, according to Consumer Credit Counseling. Talk with the lender about the purpose of the loan to select the right loan term.
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Ask the plan administrator for the 401k loan interest rate. These loans typically offer low interest rates. Since the debt is secured by the 401k account, lender risk is low. A typical interest rate is prime rate plus 1 percent. Check out the current prime rate in The Wall Street Journal.
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Set up loan payments. Most 401k plan administrators require payroll deductions. Fill out the administrator's form to provide your bank account information. Typically, a deduction is made from each check. For example, if the loan payment is $200 and you get paid twice monthly, a $100 deduction is taken from each paycheck.
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Tips & Warnings
Consider the drawbacks of borrowing against a 401k plan. For example, if you borrow $10,000, you will lose the investment returns on these funds over the term of the loan.
Talk with your plan administrator about loan distribution options. Some administrators will mail a check. Others offer an automatic deposit option. An automatic deposit into your bank account is usually quicker in an emergency situation.
If you make late payments on a 401k loan or go into default, you will be liable for penalties. This is usually a 10 percent penalty plus the appropriate taxes (based on your personal tax rate). Even if the plan doesn't require it, set up payroll deduction to avoid these penalties.
If you leave your company for most any reason (layoff, buyout or job change), you are required to pay back the loan within a specific period of time. This varies by plan administrator, but typically is 60 days. If you don't pay back the loan, the funds are subject to default and IRS withdrawal penalties.
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