401(k) Plan Loans

Your 401(k) plan offers you the ability to take a loan. Should you do it? While most experts agree that you should avoid taking a loan from your 401(k), there may be some reasonable situations where it could make sense. Before we get to that, however, you should have a better understanding of the requirements for taking out a loan from your retirement account.

As stated above, your plan document must explicitly allow for plan loans. While 401(k) plans allow for the availability of a loan, your plan must clearly state this as an option. There is an added expense to your plan sponsor so allowing them is not universal. While most offer exactly one loan at a time, it’s possibly for a plan to allow more than one simultaneous loan to a single participant.

Once you are certain that you may take a loan, how much is available? Here too, the plan may limit the amount. In no way, however, may it be greater than 50% of your vested account balance or $50,000. If multiple loans are allowed, their sum may not exceed these numbers and further restricted to limit based on the first loan’s highest balance in the previous 12-month period. In some cases, due to the added work involved, plans may require a minimum value required to take out a loan. Your vested account balance is the total amount that you would keep if you were to terminate employment. This amount is commonly listed as part of your monthly account statement. It includes the entire amount that you’ve contributed in both salary deferrals and any rollover contributions along with any earnings on these contributions. Additionally, a portion of your employer’s contributions and any corresponding earnings will be added to this amount. If you are using the loan for the first time purchase of a primary residence, you may exceed the 50% value in order to take out $10,000 as the property will be used to secure the note.

Of course, any loan you take out, must be paid back. The IRS requires that the term of any loan be paid back at a minimum in equal quarterly installments over a term not to exceed five years and at a reasonable rate of interest which is commonly 1% over the prime rate. The one exception to the five year term is for a purchase of a primary residence which can exceed this term. Know that unlike a mortgage, a plan loan from your 401(k) account does not offer a tax deduction on the interest payments. Failure to meet the payback terms will cause the loan to become in default and, generally, if not corrected in the subsequent quarter, will ultimately lead to a deemed distribution. This will result in the outstanding balance becoming taxable income for the calendar year of the deemed default and, if you are under 59 ½, you’ll also be hit with a 10% early withdrawal penalty. Incidentally, if you are terminated or change jobs, you may be required to immediately pay off the loan balance.

With all these rules, you might be asking yourself if it’s ever worthwhile to take a loan from your retirement account. The primary downside is that you are reducing your overall retirement account balance. Even though you will be paying off the loan with interest, you are not allowing the loaned money to generate any additional earnings. The missed earnings are typically not made whole by the interest payments. Add to this the notion that most workers have not saved up enough for retirement in the first place, the idea of further reducing the overall balance is frequently not a wise decision. Most individuals would be better served by using other sources for short-term needs (such as a HELoC). Having said that, however, there are advantages to taking out a loan from your 401(k) account. With a relatively low interest rate and no credit check, a short-term loan is a relatively easy procedure. Some common reasons why one might utilize a 401(k) loan include a home purchase, to pay down much-higher-rate debt, and even to advance your education. Using money for a home purchase might allow you to increase your down payment to 20% in order to eliminate private mortgage insurance. Paying down high-interest-rate credit cards with a much lower rate 401(k) loan could also save money, let alone help your credit score. And finally, advancing your education could not only protect your current employment, but also increase your opportunities for employment and salary growth. Essentially investing in yourself – your greatest asset.

So while the decision is up to you, be certain that you understand the risks, have a reliable plan to pay the loan down in full, and can continue to fund your retirement account at the same level as you have done previously.