The New Commonsense Guide to Your 401(k): Rebuilding Your Portfolio From The Bottom up

Chapter 28. Taking Loans

THE EASIEST WAY to tap into your 401(k) account is to take a loan from your plan. Most 401(k) plans have loan provisions. Usually, you can use the money for whatever you like—to make a down payment on a home, to buy a car, to take a vacation, or to satisfy just about any other need you have for ready cash.

Tapping your 401(k) account for a loan offers several advantages over going to a bank. First, you qualify for a loan simply by having money in the plan. Second, the interest you pay goes into your retirement account rather than to the bank. Individual employers set their own rules governing plan loans.

The Department of Labor and the Internal Revenue Service (IRS) add some requirements and rules of their own. For example, to avoid paying tax on the money, plan participants can borrow no more than 50 percent of the money in their plan. The money must be repaid within five years unless it is a loan for a home, in which case the term is set by the employer. The most common term for a 401(k) loan is ten years, but some can run up to thirty years.

Although the employer sets the interest rate, the Department of Labor prohibits loans at a below-market rate. In other words, your employer must charge you roughly the same as a bank would charge customers like you. As a result, most employers tie their interest rate to the prime rate, the base rate on corporate loans at large money-center banks.

You can expect to pay one or two percentage points above the prime. Many ...