Is there anything your 401(k) plan can't do? It allows for
tax-deferred earnings in traditional accounts and tax-free earnings
in Roth-style accounts. And traditional plans enable you to make
contributions in pretax dollars, helping to reduce your taxable
income. It even offers a menu of professionally managed investments
from which to choose.
But there may be another feature of your 401(k) (or a similar
retirement plan) that you haven't considered: You may actually be
able to borrow money from your account.1 In 2012, the
Employee Benefit Research Institute revealed that 59% of 401(k)
plans that were surveyed offered loans to participants.
Read the Rules First
The IRS currently allows you to borrow up to 50% of the total
vested assets in your account, up to a maximum of $50,000. There
may be loan minimums and certain other restrictions, depending on
your plan's specific loan availability calculations.
Here's how a 401(k) loan works: The 401(k) sponsor (your
employer) sells a portion of the plan investments from your account
equal in value to the loan amount. If your 401(k) account is
invested 70% in a stock mutual fund and 30% in a fixed-income
mutual fund, the assets will be sold in the same proportions. The
loan payments you make will be reinvested in whatever your
then-current allocations are.
Money borrowed for other purposes, such as a new automobile,
must generally be repaid within five years. However, you may be
able to repay a loan taken to purchase a primary residence over a
longer period. Specific terms of the loan -- frequency of payments
and the interest rate -- will be determined by your company, which
may allow you to make payments on a loan through payroll deduction.
IRS rules require payments to be made at least quarterly.
Check the Rules Before You Borrow
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- You can generally borrow up to half the vested amount in your
account, but no more than $50,000.
- The loan must generally be paid back within five years. If the
loan is used to purchase a house, you may have more time to repay
the balance.
- If you leave the company before repaying the loan, the balance
could be treated as a distribution on which you'll be required to
pay taxes and possibly a 10% early withdrawal penalty on all pretax
contributions and earnings withdrawn.
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Weigh the Pros ...
For some, the primary attraction of a 401(k) loan is the
simplicity and privacy not generally associated with a bank or
finance company. And unlike banks and other sources of loans, there
is no need to fear being turned down for the money when borrowing
from a 401(k) plan.
Another benefit may be competitive interest rates, which are
generally tied to the prime rate. This interest is not tax
deductible, however, and may actually "cost" you more than some
other types of financing, such as a home equity loan which may
allow you to deduct interest. The interest you pay on a plan loan
goes directly into your 401(k) account and can then continue to
grow tax deferred or tax free for your long-term needs.
... And Cons
While these advantages may make a retirement plan loan
appealing, there are several other points you should consider.
First, if you are separated from the company through which you took
the loan before you fully repay the money, you may be required to
pay the balance within 30 days or pay federal income taxes on it.
You could also be charged a 10% early withdrawal penalty by the
IRS.
Second, be aware of the potential "opportunity cost" of
borrowing from a 401(k) plan -- the cost of any potential return
you'll miss out on if the interest rate on the loan is lower than
the account's rate of return. For instance, if you borrow money
from an account earning 10% and you pay 7% interest on the loan,
you miss out on a potential 3% return on the balance of the loan.
Over time, the missed earnings can add up and result in a lower
balance in retirement savings. Also, keep in mind that returns in
stock and bond markets are not constant -- the average return is
often earned in a few market surges occurring over a few days or
weeks. If your plan money is out of the market when those surges
occur, your opportunity cost could be much higher than you
expected.
Also take note of any fees charged for retirement plan loans by
your company. Finally, some companies set deadlines for applying
for loans and may take up to two months to process the
application.
Survey of 401(k) Plans on Plan Loans
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- 87% of respondents had access to plan loans.
- Only 18% of eligible participants had loans.
- The average loan balance was $7,153.
- Only 15% of participants with account balances of less than
$10,000 had loans outstanding.
Source: Employee Benefit Research Institute, December 2013,
based on 2012 data (latest available).
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Make the Most of Your Retirement Plan
The primary reason to invest in an employer-sponsored qualified
retirement plan, such as a 401(k) plan, is to pursue your long-term
financial goals. Remember, the earlier you invest and the longer
you stay invested, the more you'll potentially benefit from
tax-deferred or tax-free compounding.
But if you've accumulated assets in your account and you're in
need of a loan, a retirement plan could be a source of funds.
