The 401k Loan: How to Borrow Money From Your Retirement Plan and What You Need to Know

how to read 401k statement

The 401k Loan May Have Benefits, but it Isn’t Without Pitfalls

Roughly 75% of 401k plans have a loan provision. This is good news for participants who find themselves in a bind and need quick access to some cash, but it also potentially puts a lot of retirement nest eggs at risk. In fact, about 30% of employees who have the ability to take a loan from their 401k plan have done so and currently have an outstanding loan balance. This number picked up a bit during the economic downturn as people found themselves in difficult situations and in need of a little extra money.

In an ideal world we’d leave our retirement plans alone, rely on our emergency fund in a time of need, and continue adding the maximum 401k contribution. But let’s face it, life happens. As much as we try to plan ahead and put money aside for that very reason there are times when that just isn’t possible or those funds aren’t sufficient to cover a major crisis. So, having the ability to tap into your 401k a little early may be your saving grace. Unfortunately, it isn’t all sunshine and rainbows. Taking a loan against your 401k may have devastating consequences if you’re not careful and the decision to borrow from your retirement nest egg should not be taken lightly.

401k Loan Basics

While each plan may set their own specific loan features and restrictions there are a number of similarities. Even so, if you are considering a loan, be sure to check with your plan provider to see what the requirements are for you.

  • Most plans have a minimum loan amount which is often $500 or $1,000. The good news is that this keeps people from taking small and frequent loans for things they can probably find the cash for elsewhere, but it also means you may need some time to repay the loan if it’s more than you actually need.
  • Plans typically allow you to borrow up to 50% of your vested balance up to $50,000. Keep in mind that not all plans will allow you to borrow from the vested company match and it may restrict you to your personal vested balance. On the other hand, the available vested balance typically does include amounts rolled over into the 401k from an outside account.
  • Personal loans have a maximum repayment term of five years, but most plans also allow home loans to be taken for the purchase of a new primary residence. Additional documentation may be required to prove the home purchase, but those loans generally have a 15-year term.
  • In most cases your loan must be paid with equal installments taken directly from your paycheck over the life of the loan. Once the loan has been issued you usually can’t change the payment terms, although some plans do allow you to pay off the loan in full early.
  • The interest rate is often set as the prime rate plus 1%. The loans use a fixed rate and will be set on the day the loan is issued.
  • Loan origination fees may exist and you can expect to pay anywhere from $25 to $100 just to process the loan.
  • Loans proceeds are not taxed at the time of the distribution, but would be taxed in the event of a default.

The Advantages of a 401k Loan

Don’t get me wrong, there are far worse things you can do in a time of need than borrow some money from your retirement account. Racking up credit card bills, getting your vehicle repossessed, home foreclosed upon, or resorting to payday loans are very bad alternatives. So, there are some situations in which a 401k loan has an advantage.

One of the best benefits is that there’s very little paperwork to fill out and most loans are issued regardless of your needs. With many plans it can be as easy as logging into your account online and clicking a few buttons to have a loan issued. It can then be sent in a few days via check or possibly even deposited directly into your checking account. And unless you’re requesting a loan for the purchase of a home, most plans don’t care why you’re asking for the money and you are under no obligation to tell them. Try getting a loan at the bank without filling out a mountain of paperwork or running a credit check. It won’t happen, so because of this simplicity the 401k loan has an advantage.

Let’s talk about interest. When you borrow money from a bank or charge something on a credit card you need to repay the loan plus interest. In these cases you pay the bank the interest. So, you may need to borrow $2,000 but after all said and done you may have shelled out $3,000 to pay off the balance. The bank just made off with $1,000 of your money. With a 401k loan you pay yourself the interest. If you borrow $2,000 from your account and interest charges over the life of the loan totaled $1,000 you actually put that extra $1,000 back into your 401k. Keep in mind that some of that money was paid back in with after-tax money, but the net result is far better than giving those finance charges to a bank or credit card company.

The Disadvantages of a 401k Loan

While a 401k loan clearly has some advantages over traditional borrowing, let’s not forget that there are plenty of disadvantages that should have you thinking twice before borrowing from 401k .

  • Don’t ignore fees. These loans usually aren’t free, and as mentioned above there is typically a loan origination fee of anywhere up to $100. In addition, there may be an annual maintenance fee. If you are borrowing $1,000 and they charge you a $75 origination fee that’s 7.5% of the loan. If there’s an additional $25 annual maintenance fee and you require three years to repay the loan you just spent another 7.5%. That $1,000 loan that seemed like a good idea actually cost you $150 in fees, or 15%.
  • If you default on your loan it won’t hurt your credit score . but it could be even more damaging to your finances. Defaults are treated as a distribution, which means your money is then taxed and you must also pay the 10% early withdrawal penalty if you’re under age 59.5. If you already spent the loan proceeds and wasn’t planning on having a major taxable event this could lead to big problems come April 15th.
  • There’s also a significant opportunity cost when taking a loan. If you pull money out of your retirement account you’re pulling money out of the market and/or safe fixed accounts as well as temporarily eliminating the tax-deferred growth that money would have otherwise been earning.
  • The market can also move between when you take a loan and when you repay it. If you’re unfortunate enough to take a loan while the market is at a bottom and then begins going back up you’ve done even more damage to your retirement account as you’ve cashed out some money at a low point and will be buying back in over the coming years while the market is high. Of course the opposite is also true, but this is a game you shouldn’t be playing with your nest egg.
  • You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 401k is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement.

Choosing Which Investments to Borrow Against

Some loans do not give you a choice and

they will simply take an equal portion out of each investment to cover the loan proceeds. This means if you have 80% in stocks and 20% in a fixed account and request a $10,000 loan they will pull $8,000 from your stock holdings and 20% from your fixed account. If you don’t have a say in this matter there isn’t much you can do.

If you can choose where to pull the money from the loan there is a strategy you can use that may minimize the negative impact on your investments. If at all possible, you should consider pulling your loan from the fixed income portion of your portfolio. This is especially true in a low rate environment where your fixed income allocation may be earning just a few percent each year. The thing about this strategy is that you know exactly what your opportunity cost is if you pull money out of a fixed account.

If your fixed account is earning 2.5% currently you know that if you borrow $10,000 from that part of your portfolio you’re only giving up a 2.5% return on that money in the first year, and probably not much more in subsequent years. On a one year loan that’s like giving up $250. When you factor in the extra money you pay into your 401k while repaying the loan you’ll probably still come out ahead. Compare that to borrowing from the stock portion of your portfolio. Here, the opportunity cost cannot be determined until after the fact. What happens if you pull $10,000 out of your stock funds for the loan and the market sees a 12% gain that first year? Not that you could have predicted it, but that loan just cost you $1,200. Sure, one can argue that the market could have gone down 12% and you saved yourself from losing money, but there’s no way to predict that ahead of time. A calculated risk is better than rolling the dice.

The Dangers of Default

While it was already mentioned earlier, it is worth discussing the dangers of defaulting on your loan one more time. As long as you’re an active employee with the company that maintains your 401k you have nothing to worry about since your loan payments will be made via payroll deduction. But what happens if you quit your job or get fired? In most cases, that means you only have 60 days to pay the outstanding balance of your loan before you default. When you default, your employer then reports to the IRS that you were unable to pay the loan, and they will then treat the defaulted amount as a hardship distribution. As a distribution you’ll then be required to pay taxes on the outstanding balance plus an additional 10% if you’re under age 59.5.

Let’s think about that for a minute. Say you borrow $10,000 from your 401k and you get laid off eight months later. Maybe you’ve repaid about $2,000 of the balance so far, but that means there’s still $8,000 that needs to be paid. You’re now given just 60 days to come up with $8,000 in cash or else it will be treated as a default. If you were in a difficult financial position to begin with that required you to take the loan do you really think coming up with that cash is going to be possible?

Assuming you can’t repay the loan in full and you do default that $8,000 will then get reported to the IRS as a early distribution from your retirement plan. So, come tax time you’re going to owe regular taxes on that amount plus the 10% penalty if you’re taking the distribution early. If you’re at the 25% tax rate that means your federal tax liability will be somewhere around $2,200.  Again, if you’re experiencing financial difficulties which made you take out the loan in the first place what kind of trouble might this put you in with the IRS?

Finally, don’t forget that the defaulted amount is treated as taxable income, which increases your total taxable income that determines things like tax rates and phase out limits for other tax deductions and credits. If this distribution puts you over the limit for claiming additional tax deductions or credits you’re used to it could create a massive tax liability. As you can see, defaulting on your 401k loan may have far-reaching effects.

In rare cases, some plans will give you the option to continue making your loan payments after termination via a coupon book, but even that doesn’t come without its drawbacks. Making these payments may keep you from going into default, but as long as there is a loan balance outstanding you’ll be unable to roll over your 401k to an IRA or another qualified retirement plan. This means you’re still tied to your old 401k even after termination until your loan is repaid or you default.

Other Options Before Taking a Loan

Borrowing against your 401k may be better than some alternatives, but as you can see it’s by far the best option if not done properly. And some things are completely out of your control such as losing your job after taking out the loan. We’d all like to think we’ll remain employed, but if that doesn’t happen you’re then on the hook for the remaining loan balance. So, before taking that loan there are a few things you may consider first.

Above all else, you need to create an emergency fund. If you haven’t started one already, just start small and put a little money away each week. It might not be a lot, but after you have a few hundred saved up it is going to help provide you with a little safety net that can keep you from having to resort to high-interest credit cards or taking a 401k loan for just a small and temporary emergency. I’d recommend opening a high-interest savings account online that will put your money to work, won’t burden you with fees, and keeps the money just out of arm’s reach so you don’t spend it unless you really need it.

You should also consider opening a Roth IRA at a discount broker like TradeKing. Not only is this a good idea for generating tax-free income in retirement, but these accounts also provide you a little more flexibility and let you take control of your money. One major benefit of the Roth IRA is that you are allowed to take your contributions out at any time without being taxed or paying a penalty. It still has the drawback of opportunity cost, but you have the option to take the money out of an IRA as you need it. No loan fees, no interest to repay, and you can work with your tax preparer or CPA to minimize the tax burden.

Finally, don’t underestimate the benefits of a 0% APR or low-interest credit card in a pinch. This isn’t recommended if you’re already up to your eyeballs in debt, but having a credit card on hand can still be better than taking a loan from your retirement plan. For example, say your hot water heater or other major appliance breaks and you need to spend $1,000 to get everything back to normal. You might take a 401k loan, but that will likely cost you between $50-$100 in fees plus any lost opportunity if you pull money out of an investment that increases in value. Compare that to a 0% credit card. You could put the $1,000 on there and possibly have up to a year to repay it without incurring a single fee or penny of interest. Even if you do have an interest rate of say 15%, if you schedule regular payments to have it paid off in a timely manner it may end up still costing less than taking the loan.

My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.

Source: genxfinance.com

Category: Forex

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