Advantages of a 401(k) loan include lower interest rates and the lack of necessity for bank approval or credit checks, reports Forbes. Borrowing the funds also helps 401(k) owners avoid the 10 percent penalty tax of withdrawing the money before age 59 1/2. Drawbacks include the short five-year limit of the loans, penalties for late payments or job transfers, and the decrease in earnings in the retirement funds.
As of 2015, the limit to loans from 401(k) plans is $10,000 or 50 percent of the account's balance, whichever is greater, to a maximum of $50,000, notes the Internal Revenue Service. Although loans are optional features of 401(k) plans, most administrators offer them, explains Forbes. The IRS permits loan repayments to take more than five years if the account owner uses the loan for a down payment on a primary residence. Administrators usually deduct loan payments from the employee's paycheck.
If 401(k) owners are 90 days late with a loan payment, the IRS considers it a distribution and charges income tax and the 10 percent penalty tax on it, cautions Forbes. An account owner who changes jobs and leaves the 401(k) plan has only 60 days to pay back the loan before the IRS designates the entire amount a distribution and implements the tax penalties. Funds in a 401(k) account continually earn savings towards retirement, but when the account owners borrow the money, they lose the earnings they would have accumulated as well as the interest on the loan.