In times of hardships, one may need to tap into the funds of their 401(k) account and make withdrawals. But these withdrawals are not without some significant drawbacks. If the hardship withdrawal on a 401(k) account of an employee below the age of 59 ½ does not fall in the exceptions bracket where the 10% penalty is waived off, it can spell as a greater loss to the employee’s future retirement saving amount. Apart from the 10% penalty, the employee will also have to pay income tax on the withdrawn amount. For example, if an employee below the age of 59 ½ and belonging to the 25% tax bracket, makes a withdrawal of $10, 000 from his/her account, he/she will have to pay a $1,000 as penalty and will have to pay $2,500 as tax that year. This means that the person will only be utilizing $6,500 from that $10,000.

With such repercussions, a 401(k) loan can be a good option for the employee. A 401(k) loan is different from a traditional loan because in this loan an employee borrows against their own savings. In addition to this, there are no hassles with a 401(k) loan such as credit check or attaching securities. However, since the 401(k) accounts are managed or operated by the employer or plan administrator, approving of loans is completely at their disposal. One also needs to check if their plan has a provision for a 401(k) loan in the first place. Generally majority of the plans and employers allow 401(k) loans. One advantage of a 401(k) loan over a hardship withdrawal is that the amount withdrawn can be put back in the 401(k) account.

There are certain federal rules that govern the 401(k) loans. In addition to federal rules, the employer or plan administrator may have in place their own rules for approving of the loans. If an employee wishes to take a 401(k) loan he/she should first approach the Human Resources Department or the Payroll Department of his/her company. If they are not the people who administer the company’s 401(k) plan, they can point the employee to the external entity that manages the plan. The plan administrator can then explain the terms and conditions of the 401(k) loans to the employee.

General 401(k) loan rules

• With most of the plans, one can borrow only up to 50% of their savings or $50,000, whichever is less, in loan amount.

• Interest is charged on the loan amount. However, the interest charged is paid into the employee’s 401(k) account itself and not to the plan administrator. Usually the interest rate is 1-2 percentage points higher than the current prime rate.

• Repayment of the loan is in form of fixed monthly deductions from the employee’s payroll. The employee does not have any say in the amount to be deducted and the time period of repayment. Generally the repayment spans over a period of five years where one cannot make more payment than the decided installment amount. If one wishes to repay the loan early, they have to make a one-time full payment of the remaining balance. Also it must be noted that the payments made for the loan are after-tax.

• In the event that the employee quits the job or is terminated, most 401(k) plans have a rule that the loan balance must be paid back in full within a period of 90 days. Failing to do so incurs severe penalties as the loan will be treated as an early withdrawal.

• There are also rules which govern as to how many 401(k) loans one can take and time period between them. The amount that will be approved will also depend on these factors. These differ from plan to plan.

• Some employers or plan administrators may need the employee to get their spouse’s consent (in writing) before the loan is approved.

There are other factors as well which one should consider before opting for a 401(k) loan. Most important amongst them is to understand that when a 401(k) loan is approved, one’s investments from the 401(k) account are sold off to raise the requested amount for the loan. Because of this factor, the employee loses all the future earnings he/she could have gained from these investments in the long term. This can translate into a lower retirement amount.

Also, since the installment for the loan will be deducted directly from one’s payroll, one should make sure that they have enough monthly pay to sustain themselves through the loan repayment period. Owing to all these reasons, 401(k) loans are mostly advised against. But if one has no other option than to tap into the 401(k) account, this can be the most favorable option. Again, it should be stressed that extreme caution must be taken while opting for these loans and one must plan carefully. Talking to a financial advisor or a tax lawyer should be considered as they can help one work through the details and plan accordingly.