Episode 191: September 27, 2010
Debt Loans Credit
by Laura Adams
In my previous article, Taking a 401(k) Withdrawal, I told you about the limited situations in which you’re allowed to take a withdrawal from a workplace retirement plan. I mentioned that taking a loan from your 401(k) or 403(b) might be a better option in some cases. However, taking a loan from your retirement account isn’t necessarily a wise decision, either. We’ll take a look at the potential dangers and the rules for borrowing from your workplace retirement account.
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How Do You Get a 401(k) Loan?
The first hurdle to getting a loan from your 401(k) or 403(b) is that it’s only allowed if your employer’s plan permits it. You’ll find the rules and benefits of your retirement plan in the Summary Plan Description (SPD) document, which you should receive each year. Or you can just ask your Benefits Administrator if loans are allowed. Due to the paperwork and time that’s required to administer retirement loans, it’s been my experience that small companies usually don’t offer them.
How Much Can You Borrow from a 401(k)?
If you can borrow from your retirement plan, there’s a ceiling on how much you can take out. You’re generally limited to borrowing no more than 50% of your vested account balance up to a maximum of $50,000. So, if you have $10,000 that’s vested, you can only borrow a maximum of $5,000, or 50%, from your account.
Your vested balance is the amount of money in the plan that you own. You’re always fully vested in your contributions—but amounts from your employer, such as matching funds or profit sharing, are usually subject to a vesting schedule. An employer could vest their contributions after you’ve been employed for a certain period of time, such as one or two years—that’s known as “cliff vesting.” Or they could offer “graduated vesting” where you receive 20% each year over a five year period, for example.
What Are the Terms of a 401(k) Loan?
Money that you borrow from your 401(k) or 403(b) is penalty-free if you follow all the rules—but it’s not interest-free. The interest you pay gets added to your account balance; and the rate is specified in your plan document. The loan plus interest must generally be repaid within five years. The loan payments are usually withheld from your paycheck on an after-tax basis in level amounts over the life of the loan.
Taking a loan from a 401(k) or a 403(b) can be a better alternative than taking a hardship withdrawal because you’re allowed to make new contributions to the account while you repay the loan. You might remember from my previous post that a hardship withdrawal is very different from a loan because it can’t be repaid and usually comes with a six-month waiting period where you’re prohibited from making any new contributions.
Is a 401(k) Loan Taxable?
If you’re younger than 59½ and lose your job while you’re repaying a loan, the entire outstanding balance is due right away, usually within 60 to 90 days.
Not only can taking a loan from your 401(k) or 403(b) leave you with less money for retirement, but it can also put you in a tight spot if you leave your employer or get fired before the loan is fully repaid. If you’re younger than 59½ and lose your job while you’re repaying a loan, the entire outstanding balance is due right away, usually within 60 to 90 days. If you don’t pay the entire loan back by the due date established in your plan, the outstanding balance is considered an early withdrawal, subject to ordinary income tax plus a 10% penalty. So be sure that all is well with your job before you decide to take a retirement account loan!
Another disadvantage to taking a loan from your retirement account is that the interest you pay isn’t tax deductible. If you plan to use the money to pay for education or to buy a home, for instance, you’d be better off getting a student loan or a mortgage. That’s because a mortgage, a home equity loan, and a student loan all come with a tax deduction for the interest you pay, which allows you reduce your taxable income and save money on taxes. Additionally the interest rate on those types of loans may be lower than what you have to pay back to your retirement account, in some cases.
What Are the Dangers of Taking a 401(k) Loan?
In addition to paying interest when you take a loan from your retirement plan, you will most likely also suffer a loss in earnings by taking the money out. Here’s an example: Let’s say you borrow $5,000 from your 401(k) and miss out on 6% growth on those funds. If you have to pay 7% interest on the loan when you put money back into your account, you might think that the additional interest you’re adding in would be enough to cover your losses.
However, if you repay the loan on time and have another 35 years to go before retirement, it’s likely that you’d still miss out on over $8,000 of growth in the account. If something unforeseen happens and you don’t repay the loan on time, making it an early distribution, you’d face income taxes plus a 10% penalty. In that case, you could potentially come up short by over $47,000 by the time you retire. Run the numbers for your situation using a 401(k) loan calculator to see the long-term consequences of taking a retirement account loan.
Should You Take a 401(k) Loan?
Whether you should take a loan from your 401(k) or 403(b) depends on your circumstances and how you plan to use the money. Let’s say your job is secure and you’re younger than 59½. If you were to take a loan from your 401(k) at 7% interest, that would be a better option than taking a hardship withdrawal and paying income tax plus a 10% penalty. A loan allows you to return the money plus the extra interest to the account, so it keeps working for you over time. However, as I demonstrated in my examples, taking a loan can significantly reduce your earnings and the total amount that you’ll have for retirement.
A quick and dirty tip is to consider all your other options, such as getting a mortgage, a home equity loan, a student loan, or using money in your IRA, before you borrow from your 401(k) or 403(b).
The rules for taking early distributions from an IRA are different than for workplace retirement plans. You can withdraw certain amounts of money from an IRA penalty-free for some expenses, such as higher education or to buy or build your first home. Find out more about the rules for IRA withdrawals in IRS Publication 590.
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IRS Publication 575, Pension and Annuity Income
IRS Publication 590, Individual Retirement Arrangements
Bankrate.com Retirement Calculators