Today, the majority of 401k plans include provisions for a participant 401k loan. That means an employee can borrow money from his or her account and repay it through payroll deduction without incurring taxes or penalties.
This article examines the details of 401k loans and discusses the pros and cons of taking a loan from retirement savings.
How Does a 401k Loan Work?
You should consult your Summary Plan Description for the availability and details regarding a 401k Loan for your specific retirement plan. In general, a participant is allowed to borrow up to the lesser of:
- 50% of the vested account balance or
The participant typically has five years to repay the loan, usually at competitive interest rates. The rules that govern 401k plan loans require that any loan amount not repaid within five years will be treated as a distribution from the plan, subject to taxes and, if the participant is younger than 59½, early withdrawal penalties.
Though not precisely specified in the tax laws, more time is allowed to repay the loan (up to ten years) if the loan is to be used as the down-payment on a primary residence.
Most plan sponsors do not restrict how the money is used. No credit check is preformed, because the funds in the account serve as collateral. Also, many of the larger plans are automated, so all the participant has to do is call in the request or make the request online, and a check will be sent in a few days.
Some 401k plans allow participants to have only one loan outstanding at any given time. Other retirement plans may allow a limit of two loans outstanding; while other plans may have an even higher limit. Plan sponsors are well-advised to consider limiting concurrent loans to help reduce “perpetual borrowers.”
401k Loan Interest Rates
Moreover, interest and principal on the loan are repaid to the account, usually through an automatic payroll deduction. Plans are required to charge a market interest rate—usually prime plus one or two percentage points.
Once a loan is made to a participant, the interest rate is fixed for the period of the loan. The interest that is charged is credited back to the participant’s account, so in some sense, they are paying interest to themselves. This helps to offset the fact that the borrowed money is no longer being invested for retirement.
Plan sponsors are tasked with setting the loan interest rate. If you do not want that responsibility, there are 401k vendors who will adjust the rate based on the current prime rate. Please contact us, your 401k advisors, to learn more.
401k Loan Fees
In addition to interest charges, most 401k loans have fees associated with them which will vary based on the specific retirement plan and 401k vendor.
A 401k vendor may charge an upfront processing fee (for example, a $150 one-time fee).
Other 401k plans may charge an annual or monthly fee as long as there is an outstanding loan amount. This is because a 401k loan requires extra recordkeeping such as loan amortization and payment processing. Participants need to be fully informed before they take a loan, so they can understand all charges and expenses.
Advisors Recommend Against 401k Loan
Financial advisors do not recommend participants take loans from their 401k plans unless it is absolutely necessary, because it is too easy to delay or to choose not to repay the loan, thus defeating the purpose of the plan. The whole point of saving money in a 401k is to leave it invested so that it will grow tax-deferred until withdrawn.
In fact, some 401k advisors recommend that plan sponsors do not allow loan provisions within their retirement plans, so participants keep their retirement savings intact.
If the participant loses his or her job or leaves for a better opportunity, the loan becomes due immediately. If the loan cannot be repaid, then it is treated as an early withdrawal and penalties and taxes become due.
If a 401k loan is considered, the employee should be reasonably assured that his or her job is secure until the loan is paid off. A large percentage of 401k loans are used for nonessential purchases. Even if the loan is repaid within the five-year period, keep in mind those will have been five years on which the participant is not earning investment returns on the outstanding loan balance.
Reasons Not to Take a 401k Loan
The three key reasons to not take a 401k loan:
- Participant loses the tax-deferred investment growth on the money withdrawn.
- Participant replaces pre-tax money with after-tax money. So, in the 28 percent tax bracket, it takes $1.39 in earned salary to replace each dollar borrowed from the 401k plan.
- If the person leaves a current employer, he or she will have to repay the loan immediately. Failure to do so has unfortunate tax consequences:
- The amount of any plan distribution to the terminating employee will be reduced by the outstanding loan amount.
- If the individual does not “make up” the offset amount from his or her own pocket, it will be included in his or her gross income and income taxes will apply. If he or she is younger than 59½, a 10 percent penalty will be assessed on the taxable amount.
401k Loan or Hardship Withdrawals
If you are experiencing a time of extreme financial difficulty, you may want to learn more about taking a 401k hardship withdrawal. More information hardship withdrawals can be found here.
If you are a plan sponsor with questions regarding your 401k loan provisions, please contact us, your 401k Advisors.Related Topics
- 401k loan rules