401k Loan

The Internal Revenue Code allows more flexibility and latitude about 401k loans than your employer's plan rules probably will grant. The law does not restrict 401k loans, but it also does not require your employer to offer them. Although most major corporations do provide 401k loans for employees experiencing temporary financial difficulties, they must comply with strict guidelines about how to manage them. When your employer sets-out your 401k loan's terms and conditions, saying "my hands are tied," he means it.

Do not get confused by a tricky distinction in the law: The Internal Revenue Code mandates how your employer must set-up and pay-out your loan; it sets limits on how much you can borrow; and it establishes the timeline and requirements for repayment. The Internal Revenue Code also establishes the consequences for default. But the law says nothing about why employees do or do not qualify for 401k loans.

Your employer maintains complete discretion over conditions, circumstances, and restrictions on 401k loans. And if you work for a relatively small company, your employer simply may not offer 401k loans because they add too much to his administrative costs. The majority of large corporations will allow 401k loans when (1) employees pay college costs for their children, their spouses, or their children; or (2) the 401k loan will prevent eviction from or foreclosure on their homes; (3) the money pays reimbursed medical costs-co-pays or the cost of procedures insurance does not cover; or (4) the loan goes toward the first-time purchase of a home.

Internal Revenue agents and 401k specialists advise your employer on limits and guidelines for 401k loans: Because they pay administrative costs for managing your loan, most employers set a minimum loan amount-typically $1000. They also set the ceilings on 401k loans-typically 50% of your vested amount. If you're married, your employer may require your spouse's consent to the loan. Especially in "community property" states where your spouse could be saddled with the debt in the case of separation and divorce, he or she has a right to full disclosure and informed consent. Your employer probably then will stipulate that your loan payments must be deducted from your paycheck; although the stipulation seems to protect him against default, it actually does more to protect you.

Naturally, because you are, in effect, borrowing money from yourself, the loan requires no credit check, and most details about 401k loans are not forwarded to credit reporting agencies. You do, however, have to pay interest. The interest payments actually make up for lost earnings on your principal, so that they work to your long-term benefit. The interest rates almost always remain extremely low-usually the Federal Reserve's Prime Rate plus 1%, which definitely qualifies as a "preferred rate."

As with all major financial decisions, you should not take out a 401k loan in haste and without professional advice. At work, talk to your 401k Plan Administrator, and then talk to your tax person or your financial planner.