Tuesday, March 25, 2014

What You Should Know About 401(k) Loans

According to 401k.org, about 20% of Americans eligible for a 401k loan have one, and the average outstanding loan balance is $7,600. As 401k loans are an option for many, it is a good idea to familiarize yourself with this tool. Additionally, be aware that not all 401(k) plans allow employees to borrow from their accounts. Check with your H.R. department before you even begin to consider a loan.

The maximum loan amount allowed is restricted to the lesser of half the vested account balance or $50,000. While interest rates vary by plan, the most common rate is the prime rate plus one percent. Unless lent funds are used to purchase a home, most 401k loans must be fully repaid within five years.

The Advantages:

  • Loans are not subject to income tax or early withdrawal penalties (unless the loan defaults).
  • Loans are convenient. There is no credit check or long application form.
  • Loans have low interest rates. Most 401k loans are cheaper than rates charged by credit cards.
  • Interest paid on the loan is paid to yourself, not a bank or other lender.

The Disadvantages:

  • Borrowed money will not be invested in the market so potential investment gains will be forfeited.
  • Borrowed funds will be taxed twice! Borrowers earn wages, pay taxes on those wages, and use those after-tax funds to repay the loan. During retirement, the retiree will again pay taxes on withdrawn funds. Consider an investor who is in the 25% federal tax bracket – being tax twice would be extremely expensive.
  • Investors with a 401k loan ultimately contribute less to their retirement plan because a portion of new contributions will go towards paying off the loan.
  • If you cease working with your current employer, your entire loan is usually due within 60 days. If you can’t repay the loan, it is considered defaulted and you will be taxed on the outstanding amount and subject to a 10% early withdrawal penalty if you are under age 59½.
Generally, I feel that a 401(k) loan should be considered only if it’s essential and all other financial resources have been exhausted. However, there are instances when a 401(k) loan can be a fantastic solution. For instance, I have a client who expects to receive an inheritance within the next few months. However, this client would like to purchase a new home immediately and needs funds for a down payment. It makes sense for this client to borrow from his 401(k) plan in order to cover the initial cost of the home loan and repay the loan in full once the inheritance is received. This enables this individual to borrow funds inexpensively but then not forfeit the great benefits provided by his retirement plan.

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