One of the most common questions we receive from 401k participants is whether or not it is a good idea to take a loan out from their 401k plan account. I applaud those that take the time to ask this question first and not rush to a decision without taking all the data into consideration. We’ll review when it may be good to consider a 401k loan, and when you may consider not taking a 401k loan as well as various pros’ and con’s to consider. Once you have all the data and determine how it may impact you, then you can make an educated decision on whether or not it is a good idea to take a loan out of your 401k plan account.
Before I go into the details, lets cover some basics first. Your 401k account is an important and effective savings vehicle that is vital for your retirement income needs. First you need to confirm if your company’s plan allows for a loan. Not all plans do. Keep in mind you are borrowing money from yourself and not another type of lender like a typical loan. With your plan’s loan policy statement you will be able to identify the provisions of taking out a loan and the details you need to follow. Majority 401k loan provisions require you to repay the loan amount with some type of applied interest rate (most common is current prime interest rate +1%). Currently, the prime interest rate is at 3.25%, so that plus 1% would make your applied 401k loan interest rate 4.25%. If you are not sure, you can consult with your HR team or your plan’s advisor to review the details with you.
Most loan provisions have a $1,000 minimum loan amount and allow for a maximum loan amount up to 50% of your vested account balance, not to exceed $50,000. Keep in mind these amounts are only taking your vested account balance, which is the portion of your account balance that is currently fully yours, into consideration. Your employee deferrals are always 100% and the employer portion of your account balance may only be partially vested. You would need a vested account balance of $100,000 to take out the maximum loan amount of $50,000.
Another provision to understanding is the loan pay back period. You must pay back the loan within five years. Your loan provisions may allow for an extended period if the loan is for the purchase of a primary residential home (key work is primary!).
When you may consider a loan
Now that we got some of the basics out of the way, let us now talk about when you might possibly consider taking a loan from your 401k account. First and foremost, it is important to maintain these assets for their true purpose, your retirement!! But we do understand that unforeseen circumstances can happen.
- You are in an immediate, high-cost financial need due to unforeseen medical expenses and or home repairs (like a new air conditioning unit) and you do not have the cash available or any other means to pay for these expenses right away.
- Perhaps you have a large balance in high interest credit card debt, then considering a lower interest rate 401k loan and paying yourself back may make financial sense.
- You can usually complete the loan application process and initiate online through your recordkeeper provider quickly for processing.
- Loan repayments are automatically set up for you with HR via payroll deductions.
- The loan is made on a tax-free basis.
- There is no credit lender to deal with.
- Normally a much lower interest rate than what you would get from a bank/lender.
- No minimum credit score is required to qualify for the loan.
- The loan amount is not reported on your credit report as debt.
- No income tax or a penalty tax on the withdrawn amount (unless loan defaults).
When you may not consider a loan
Really, we want you to think of tapping into your 401k account as a last resort option. Here are some thoughts on why you might not consider a loan and cons to take into consideration.
- Potential of leaving current employer before loan is fully paid.
- The reason for your loan is more of a want, than a need. For example, if you are looking to purchase a boat or do some home remodeling, you would not want to jeopardize your retirement savings for something that is not a necessity.
- The number one con is the potential loss of investment gains on the money you borrow from your 401k retirement savings which may have a significant impact on your long-term financial retirement future.
- The amount you need may exceed what you are able to take out a loan for.
- If you terminate employment from your current employer, any outstanding balance is required to be paid back in full or your outstanding loan balance will be treated as a taxable distribution. If you are under the age of 59 ½ you will also incur an additional 10% early withdrawal penalty.
- You will lose the asset protection of these assets under ERISA if you happen to go through bankruptcy.
Be sure to do your due diligence and determine if there are any other options available outside of taking a loan from your 401k plan. Here are some ideas to consider first.
- Does your plan allow for a hardship and due to your circumstances would you qualify? Keep in mind if you are under the age of 59 ½ you will incur a 10% early withdrawal penalty fee.
- With the low interest rate environment, you may want to research and see if you can get a loan from the bank at a decent interest rate. You may be better off with a slightly higher interest rate than losing out in potential earnings on the money pulled out of your 401k.
- Is a personal loan from a relative an option? I get this may be a difficult one to address but an option to be taken into consideration.
- If you have high debt and are looking to consolidate, you can seek the assistance of a credit counselor.
- If you have high debt, you might also consult with a bankruptcy attorney to see if this last resort option is a good fit, providing you with an opportunity to clear your debt and maintain your 401k savings. Please know there may be serious consequences to this option, but it may be one to research.
Be prepared that the risks and disadvantages of taking a 401k loan may outweigh the advantages. If you are ever in doubt, please do not hesitate to call us to walk through your scenario and see what the best option may be for your specific situation. As you can see there are many pros and cons to consider and having the opportunity to talk it through with a financial professional is a great option you have available to you.
Please contact your Henry+Horne Wealth Management advisor with any questions.
Andrea Donaldson is Vice President of retirement plans for Henry+Horne Wealth Management. She can be reached at [email protected] or 480-483-3489.