401(k) loans
American workers may find themselves considering their 401(k) plans when they’re in need of a loan. 401(k) loans are pretty easy to get, especially when compared to other types of loans. First of all, there’s no credit check and no collateral required, since you’re borrowing money from yourself. And, the payments and interest you’ll pay are going back into your 401(k) account. A loan on your 401(k) is always better than taking an early withdrawal and paying the taxes and penalty, but it should still be your last choice in funding.
The law dictates a few rules about 401(k) loans.
For starters, employers have the choice of whether to offer 401(k) loans at all, but if they do, they must make the loans reasonably available to all participants. The amount of the loan cannot exceed 50% of your vested account balance, or $50,000, whichever is less. Also, the loan balance must be paid back, with interest.
The interest rate must be “competitive”, but the actual rate will be determined by your employer, commonly the Prime Rate plus a point or two. Loans must be paid back within five years, and thirty for a loan for your primary residence. And finally, if the loan is not paid back in accordance with the rules, the IRS will consider the loan to be a non-qualified distribution, resulting in a 10% penalty for early withdrawal, in addition to state and federal income taxes.
The rest of 401(k) loan guidelines will be determined by your employer.
As mentioned earlier, whether to offer loans is the company’s choice, and not required by law. Most big companies allow their employees to borrow money from their 401(k) plan. Smaller companies may be less likely to allow loans on your 401(k), due to the high cost of loan administration. Each company dictates their loan conditions; many employers restrict the purpose for which you receive the loan, requiring that you use it for a specific need, such as medical bills, education, or a home purchase. Also, even though the law allows thirty years for the purchase of a home, most employers will only give you ten or fifteen years to pay it back.
You’ll normally make your loan payments through a company payroll deduction. Take that as a good thing; it will ensure on-time payments. Paying back the loan is the important part, or the IRS will consider it to be an early withdrawal and you’ll owe the 10% penalty and income tax on the amount withdrawn. Some companies allow, and some even require, you to discontinue further 401(k) contributions until your loan is paid off. That can mean you’re really putting your retirement savings on the back burner. The longer you take to pay off your loan, the longer you’ll keep your cash out of a tax-advantaged retirement account.
Another important consideration, most companies will require that you pay the loan balance, in full, within sixty days if you leave employment with them. If you can’t manage to come up with the loan pay-off in the time allowed, your loan will be considered an early withdrawal and you’ll face penalties and income taxes on the loan amount. You may have to take out a consumer loan, get a home-equity loan, or sell your vehicle to pay off the 401(k) loan. Think twice about getting a 401(k) loan, if you feel you may move to your next employer before the loan can be paid off.
Another, less-likely option would be to transfer your loan to your new employer, that is, if both your previous and next employer allow it. The hard part about that is, that most employers will expect some time in service before you are even eligible for their 401(k) plan. If they require you to be employed with them for six months before you can participate in their 401(k) plan, then you would have missed your sixty day time-limit to pay off the loan with your previous employer. Don’t count on being able to do that, but it doesn’t hurt to ask if you have no other option.
A 401(k) loan should generally be your last resort.
Some people justify taking a 401(k) loan because they believe it’s better to pay off high-interest debt than to let their money sit in a 401(k), earning less interest than they’re paying to their credit cards. But, for the average consumer, it’s normally a bad idea. First of all, the 401(k) is a tax-advantaged account. Contributions are made before taxes, reducing your taxable income. All earnings in your 401(k) account are growing tax-deferred, and taking out a loan will rob your 401(k) of that valuable growth. Plus, you’ll be making the loan payment with after-tax income, and then you’ll pay taxes on that money when you begin to take distributions at retirement, leading to double-taxation on some of your 401(k) funds.
Consider how much damage it will do to your overall portfolio before you take out a 401(k) loan. What type of investments do you have in your 401(k)? How have your investments been doing? Is it a good time to take out a loan? It’s not very likely that your 401(k) is held in a cash position, unless you are a very conservative investor with few years to retirement. If you’re that close to retirement, then seriously reconsider taking a loan on your retirement nest egg.
If you’re like the typical 401(k) investor who has many years to retirement, then you probably have most of your funds invested more aggressively in stock mutual funds. Aggressive investors know how volatile the stock market can be, that’s why we invest for the long term. Some years take a loss, and some years take a gain, but it all balances out to significant growth after a decade or so in the market. If you take out a loan right after your 401(k) investments take a loss, you’ll be doing what you should never do with stock funds, selling low. Then, when you pay back the loan, you’ll buy back your shares at the current market price, maybe buying high. Consider the true cost of raiding your 401(k) before you take a loan.
You’ll choose which investments to sell when you take a loan on your 401(k). Be sure to sell the investment that offers the lowest return out of all your 401(k) investments. That choice can be a no-brainer if your money market fund is earning 5% and you have a stock fund that is earning10%, but it may be difficult to decide which to sell if you have a variety of stock funds.
One fund may be doing poorly now, but is about due for a turn-around. Selling that fund to pay for your loan will take your money out before you get a chance to realize any gains. Or, one fund may have had great returns for three years straight, but is due for a correction. Keeping your money in that fund will expose you to the enevitable loss, further reducing the value of your 401(k). It’s impossible to successfully time the market, but do some serious market research before you choose to sell an investment for your 401(k) loan. At least you’ll be able to make an educated guess about the right investment to sell.
If you decide a 401(k) loan is the right thing to do, be sure to pay it back on time. Stay with the employer that administered the loan, so you won’t have to scramble to come up with the full payment. Keep your other expenses at a manageable level so you have no problem making loans payments. Remember, the IRS will consider your loan to be an early withdrawal if you don’t pay back the full amount of the loan within the time-frame allowed. The taxation and penalties of an early withdrawal can cause your 401(k) loan to cost a lot more than you had planned.
A 401(k) loan may be your only answer if you need the cash for a down payment on a house, education to increase your income, or extreme medical bills. A one-time use of a 401(k) loan may help you pay for something now that will make your future better, as long as it’s carefully planned out and funds are replaced. But a 401(k) loan is the wrong answer for material items that will depreciate in value; just use discipline and save the old-fashioned way if you want money for a nicer car or a luxury vacation. Learn to treat your 401(k) for what it is, your retirement savings. Your 401(k) may be a loan option when you have no other choice, but don’t rob your future to pay for your present.
Sources:
irs.gov
401khelpcenter.com
stretcher.com
401k.org
