Retirement Plan Loans: Do They Make Sense for You?

 

Key Points

» Read the Rules First
» Check the Rules Before You Borrow
» Weigh the Pros …
» … And Cons
» Survey of 401(k) Plans on Plan Loans
» Make the Most of Your Retirement Plan
» Points to remember

Is there anything your 401(k) plan can’t do? It allows for
tax-deferred earnings in traditional accounts and tax-free earnings
in new 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. A survey published by
the Employee Benefit Research Institute in 2009 revealed that 59%
of those polled had retirement plans that offered loans.

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

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 distribution on which you’ll be required to pay taxes and possibly a 10% early withdrawal penalty on all pretax contributions and earnings withdrawn.

 

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
88% of respondents had access to plan loans. Only 16% of eligible participants had loans. The average loan balance was $7,191. Only 12% of participants with account balances of less than $10,000 had loans outstanding. Source: Employee Benefit Research Institute, 2009.

 

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.

Points to Remember

 

1. Under IRS rules, 401(k) participants can borrow half the amount
   in their account, up to a maximum of $50,000.
2. Loans generally must be repaid within five years.
3. Simplicity and privacy are considered benefits of 401(k) plan
   loans. Interest rates are also generally competitive.
4. Participants who leave their company before fully repaying a
   loan could end up owing federal income taxes and a 10% early
   withdrawal penalty on the balance.
5. Many companies charge fees for 401(k) plan loans.

 

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rights reserved.