While the Internal Revenue Service (IRS) prohibits using a 401(k) as collateral for a loan, you might be able to obtain a loan from your 401(k) account.
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IRA vs. 401(k) Funds As Collateral
Your 401(k) account differs from your IRA in part due to its structure: an IRA is held in the account holder's name; the 401(k) is held in the name of the account holder's employer on behalf of the employee. So, the 401(k) plan is unique to the employer.
Consequently, your employer decides in what circumstances you can withdraw cash from your account. For instance, often, an employer disallows 401(k) account withdrawals only in the event of significant financial hardship. Your employer's policies are a primary determinant as to whether you can use the funds in your account as loan collateral.
Another issue is the Employee Retirement Income Security Act (ERISA), which protects your account from your creditors. Should you be able to use your 401(k) account as collateral, your creditor would have a claim on the account if you defaulted on your debt.
Using 401(k) as Collateral
Depending on the policies your employer sets for the 401(k) plan, you may be able to borrow money from your account. To do so, your employer's 401(k) employer-sponsored plan must include a loan provision. Your company's Human Resources department or its 401(k) plan sponsor can discuss the plan's policy in this regard with you.
401(k) Loan Application
If your employer's plan allows you to apply for a loan using your 401(k) as collateral, you can submit a loan request to your plan sponsor, such as Fidelity Investments. The request must be less than or equal to your plan's available limit.
If your plan sponsor approves your 401(k) loan request, the sponsor will issue a check or arrange a direct deposit in the amount you requested, less loan origination fees.
401(k) Loan Amount
The IRS allows a 401(k) account owner to borrow as much as 50 percent of the account's vested value or $50,000. The vested amount is the amount of 401(k) dollar value that you will receive if you leave your job with the plan's sponsor. Your employer, however, might set a lower loan limit.
Your company's plan might require the consent of your spouse for a loan amount greater than $5,000. Also, your 401(k) plan might restrict the loan to that needed to pay medical expenses that your insurance company doesn't pay, education expenses or general financial hardship. Your company might place additional limitations on the loan.
401(k) Loan Repayment Terms
You must repay any 401(k) loan as well as the associated interest that is added to your account balance. In addition, it's typical for an employer to require that a loan must be repaid within five years. Also, it's common that an employee makes the payments through paycheck deferrals.
Should you leave your job before you repay your loan, you must repay the loan before October in the year that follows your departure. If not, the IRS reclassifies the loan to a premature distribution of funds, which is subject to income tax and a 10 percent early withdrawal penalty if you are age 59 1/2 or younger.