BY ELISABETH A. HALL, FINANCIAL PROFESSIONAL
The vast majority of 401(k)s in the U.S. allow participants to take loans and perhaps you have wondered whether a plan loan is a smart choice. For example, suppose you need to borrow $10,000 for a short time to pay high-interest debt or a college tuition bill? Would it be better to borrow this money from your own retirement plan or a bank? This article offers guidelines to help you decide.
Let’s begin with a quick review of 401(k) loan rules. In most plans, you can take one loan at a time up to the lesser of $50,000 or 50% of your vested plan balance. Most loans are repaid through payroll deduction (using after-tax dollars) on an amortizing basis over up to five years. Because your own money is liquidated from the plan to make the loan, there is no third-party lender and no credit checks or reporting. Interest is charged on the outstanding loan balance, but all interest payments go back into your account. There are no income tax consequences if the loan is repaid on schedule.
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Next, let’s identify four areas to consider in deciding whether a 401(k) plan loan is preferable to other sources of money.
1. Reason for borrowing and length of the loan – Plan loans should be used for serious financial needs, not everyday spending, and they make sense when you plan to repay the money in about a year or less. They can be attractive choices if you: 1) are using the money to pay down high-cost debts; or 2) would otherwise have to take a loan at a high interest rate. The interest that you pay on 401(k) loans really is a transfer of money from one of your pockets to another, so these loans generally have a lower borrowing cost than other sources of financing.
2. Convenience, speed and privacy – Requesting a plan loan is quick and easy, and it does not require a credit application or create an inquiry to credit rating agencies. So, it has no impact on your credit. Many 401(k)s allow loan requests to be made with a few paperless clicks on a website, and you can have a check in your hand in a few days with total privacy. You can repay the loan as quickly as you want, without a prepayment penalty. Otherwise, repayments usually are made periodically through payroll deduction (using after-tax money).
3. The investment environment – Your own plan investments are liquidated to make the loan. So, the amount of impact plan loans will have on your retirement savings progress depends on the market environment. If the rate of interest you are paying (to yourself) on the loan is about the same as any investment gains that you are sacrificing while the loan is outstanding, then the impact over a year or less should be relatively minor. Your retirement could suffer, however, if you take longer to repay the loan, because
markets tend to rise over time. Also, the interest payments (made with after-tax dollars) will be subject to tax again when plan money is withdrawn. This “double-tax impact” also tends to grow larger over longer loan repayment periods.
4. Penalties and restrictions – Before taking a plan loan, you must be fairly certain that you can pay it back (with interest) on time. Otherwise, your loan can be considered a deemed distribution from your retirement account. Such withdrawals are subject to current income tax and perhaps a 10% federal premature withdrawal penalty if taken before 59½. Also, they can restrict your ability to continue putting money in the plan and receiving employer matching contributions. A minority of 401(k)s restrict new “elective deferrals” while loans are outstanding. Prior to taking any loan, ask your company’s Human Resources Department if any such restrictions apply.
Putting these four points together, you should see that the best time to take a loan is when you need access to cash for a specific, important need over a relatively short period of time, when you might otherwise have to borrow from another sources, when you know the loan can be repaid, and when your ability to participate in the plan won’t be restricted. You also may want to consult a professional tax advisor before requesting a loan, and you should always have a clear plan in mind for repaying these amounts on schedule.
Elisabeth A. Hall is a Financial Professional with Alliance Advisory Group in Jamestown, NY. She serves as Vice President of the local National Association of Insurance and Financial Advisors for Chautauqua County and is a member of the Million Dollar Round Table. Mrs. Hall can be reached by calling (716) 483-1531 or via email at elisabeth_hall@glic.com.