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The 401(k) Loan: The Lesser of Many Evils

The 401(k) Loan: The Lesser of Many Evils

August 21, 2018
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The 401(k) loan can be a valuable tool in your financial toolbox. While we don't necessarily advise taking them, we feel that clients should know the rules and other factors that are often overlooked. Generally speaking, the point of stashing your hard-earned dollars into your employer's generously offered retirement plan is to have money the day your paycheck disappears. We advocate for our client's retirement and desired lifestyle, which is why we try to avoid advising someone to take these loans. However, we do realize that every once in a while we all get in a pinch, and not everyone is properly prepared. If your options must be reduced to borrowing funds, a 401(k) loan may be a good option, or "the lesser of many evils."

    

The Rules & Guidelines:

These loans are only available if you participate in a 401(k), 403(b), or other governmental plan and meets the requirements under Internal Revenue Code 401(a). Unfortunately, you can't take loans from IRA-type plans. Most of the previously mentioned plans allow for loans these days, however some do not (a lot of 403(b) plans do not allow it). This is a feature of employer plans that usually comes with extra costs. The ultimate determinant of loan rules will come from your specific plan's Summary Plan Description or "SPD." Yes the IRS has general rules around these loans (see below) but you must follow your employer plan's rules. The SPD will also state the procedures for obtaining the loan. Contact your HR department, Third Party Administrator, or plan provider for this document. On a side note, a plan may require the spouse of a married participant to consent to a plan loan (IRC Section 417(a)(4)).

   

The maximum amount that a plan can permit as a loan is:

  1. The greater of $10,000 or 50% of your vested account balance.

    or

  2. $50,000 

      Whichever is less

     

For example: 

If a participant has an account balance of $30,000 (fully vested), the maximum amount that he or she can borrow from the account is $15,000.

or

If a participant has $18,000 in his or her 401(k), he or she is allowed to borrow up to $10,000.

(irs.gov/retirement-plans, 2018)

NOTE: If you're looking to take a second loan from the plan and currently have an outstanding balance from the past 12 months, the calculation changes. Please consult your advisor.

     

How Does Loan Repayment Work?

If a plan provides for participant loans, then the plan must state the terms for repayment and the interest rate. However, repayment of the loan must occur within 5 years (see exception below regarding primary residence purchase), and payments must be made in substantially equal payments that include principal and interest. The payments must also be paid at least quarterly (Reg. Section 1.72(p)-1, Q&A-3). Each plan can set their own interest rate, but many use the prime rate +1% or 2%. The interest you will pay has nothing to do with your personal credit. Loan interest is paid back to yourself  through withholding from your check after-taxes.

Potential double-taxation is one pitfall with 401(k) plan loans; You are taxed on the interest payment, then likely taxed again when you take the distribution of that money in retirement. You cannot deduct interest payments from 401(k) loans on your tax return. During repayment, your plan may also prevent you from making regular pre-tax contributions (as you used to), meaning you may lose an employer match for the period of time you are repaying.

NOTE: Repayments and interest are not plan contributions! Be mindful of this if your employer offers a matching contribution!

   

If You Leave Your Job, Retire, Or Are Laid Off With An Outstanding Loan:

Due to the Tax Cuts & Jobs Act 2017 (TCJA): Effective January 1, 2018, you now have a bit longer than the traditional 60-day rollover period to pay back your unpaid balance. You have until the due date (including extensions) of your federal tax return to pay back the "plan loan-offset" (the unpaid balance). Therefore October is the longest you can wait to avoid the loan being deemed a distribution subject to ordinary income taxes, and a potential 10% penalty if under age 59 1/2. (irs.gov/retirement-plans, 2018)

   

Things To Consider

  • The true cost of a loan from your 401(k) is the potential dollars that could have been earned on the money you borrowed, if it had remained invested instead.

  • If you have not maximized contributions to receive your potential employer match for the year, you could end up missing out on "free money".

  • Your repayments are not contributions, therefore your taxable income could increase during repayment years if you are not also making contributions.

  • A loan that is taken for the purpose of purchasing a principal residence may be able to be paid back over a period of more than 5 years.
  • Loans from 401(k)s do not show up on a credit report. For purposes of qualifying to purchase a home, they do however reduce your assets (not add debt) which may slightly affect your debt/equity ratio.

  • Before taking a loan from your plan, please refer to the SPD and/or Third Party Administrator about likely administrative fees!
   

As you can see, 401(k) loans are usually not as beneficial as most people think and there are numerous things to consider. We would rather have clients plan ahead with emergency/opportunity funds for unexpected expenses and other various needs. We recognize that some will have limited resources yet want to take advantage of opportunities. Opportunities such as purchasing a home, or "buying in" to a partnership interest of one's firm. If it must come to borrowing money, a loan from yourself is typically going to be one of your best options. That being said, we hope this helps you make a informed financial decision.

   

   

Cameron Valadez is a CFP® Practitioner located in Riverside, CA.

   

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.

This is meant for educational purposes only.  It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions.  08/18