As of June of 2014, Americans hold an estimated $4.4 trillion in 401(k) retirement plans according to the collective information of the Investment Company Institute, the Federal Reserve Board, and the Department of Labor. Around 50 million people in the United States own a 401(k) account. Of those active participants, around 85% have access to their money through loan provisions. Such a high percentage means it’s a financial planning topic that is important to understand.
One of the most basic premises of 401(k) plans is that they’re strictly to be used for retirement. By law, funds must be left in the account (or in a similar retirement account) until the account owner is age 59 ½ or penalties and taxes pay apply. But what if something unpredictable occurs and the account owner needs access to the money? Most plans allow for distributions under very specific circumstances, including death, disability, retirement, termination of employment, or financial hardship. It’s important to note that these circumstances don’t waive taxes or potential penalties on the distribution; they simply allow access to the funds. However, the cost of taking a distribution can be high. Consider this example:
John is 40 years old and unmarried. He faces unexpected costs that he can’t meet, but which do qualify under his retirement plan’s financial hardship guidelines. He decides to take money out of his 401(k) account. The result? Ordinary income taxes plus a 10% excise penalty. If John’s marginal tax rate is 25%, the total tax is 35% on the distribution, not including state taxes. Ouch! Using numbers, it means that a $10,000 distribution will cost $3,500, netting John $6,500.
Instead of a distribution, John may have been able to take a loan from his 401(k) plan. Loans from qualified plans are not immediately taxable and have characteristics that may make them an attractive option. Consider the following facts about 401(k) loans:
- How much can I borrow? Most plans allow up to 50% of the account balance to be borrowed, or up to $50,000, whichever is smaller.
- Do I have to pay interest? Interest is charged on the loan, however, the interest is paid back into the participant’s account. The interest rate charged is usually based on the prime lending rate, plus an additional percentage point or two. Other benchmark rates may also be used to determine the interest rate.
- How do the payments work? Each pay period, a portion of your check is withheld for payment on the principal and interest.
- How long does the loan last? Most plans allow loans to last up to 5 years, but they may be paid back sooner.
- Are there fees? Usually, the 401(k) provider charges a small loan origination fee and an annual service fee. Check the fee disclosure document associated with your plan or call the plan provider.
- What if I no longer work at the employer who sponsors my old 401(k) plan? Plan loans are not allowed by persons not employed by the plan sponsor.
- What happens if I lose my job while I have a loan? When employment termination occurs, the loan must be repaid in full. If it is not, it becomes a taxable distribution subject to penalties (see John’s example above).
- Where can I learn more? Remember, every plan is a little different, and it isn’t a requirement to offer loans. Speak with the human resources manager or office manager at your company. Or, read the Summary Plan Description associated with your plan, which should be accessible online or in the company office.
While 401(k) loans may seem like a good solution for accessing funds, there are serious drawbacks and risks. Consider that:
- Money borrowed from the plan is removed from your asset allocation and may not be growing as effectively during the life of the loan.
- If the plan participant stops contributing while the loan is in repayment status, valuable time and contributions are lost.
- If employment is terminated, the unpaid balance may result in an expensive tax cost for the early distribution.
Don’t take the decision lightly, but do keep the knowledge of the availability of 401(k) loans in the back of your mind. After all, it’s good to have options.