Understanding Your 401(k) Loan

How 401(k) Loan Calculations Work

A 401(k) loan allows you to borrow money from your retirement savings. Unlike traditional loans, you pay yourself back, with interest, directly into your 401(k) account. The calculation typically involves:

• Loan Amount: Generally, you can borrow up to 50% of your vested account balance, or $50,000, whichever is less.
• Interest Rate: Often set at the prime rate plus 1% or 2%. This interest is paid back to your own account, not to a lender.
• Repayment Period: Typically, loans must be repaid within five years, though loans for a primary residence purchase may have longer terms.
• Payment Frequency: Repayments are usually made via payroll deductions, ensuring consistent payments.

Example Calculation

Let's say you have a vested 401(k) balance of $100,000 and you decide to borrow $25,000. Your plan's interest rate is 5% and the repayment term is 5 years (60 months).

Using a standard amortization formula, your monthly payment would be approximately $471.78. Over the 5 years, you would pay back the $25,000 principal plus about $3,307.00 in interest, all of which goes back into your 401(k) account.

Important Considerations

• Lost Growth: Money borrowed from your 401(k) is not invested and therefore misses out on potential market gains during the loan period.
• Tax Implications: If you fail to repay the loan on time, the outstanding balance may be considered a taxable distribution and could be subject to a 10% early withdrawal penalty if you are under 59½.
• Job Separation: If you leave your job, you typically have a short period (e.g., 60-90 days) to repay the entire outstanding loan balance, or it will be treated as a taxable distribution.
• Fees: Some plans may charge administrative fees for initiating or maintaining a 401(k) loan.
• Impact on Contributions: While repaying a loan, some individuals may reduce their regular 401(k) contributions, potentially slowing down their retirement savings.