401(k) Loans: What to Know Before You Borrow
Last week I wrote about when it's a good idea to take a 401(k) loan.
Over 75% of employers 401(k) plans permit plan participants - which is an employee on payroll and has an account balance - to take 401(k) plan loans. About one in every four individuals has a loan outstanding from their 401(k).
Loans can be made from plans for any reason. Under rules set up by employer's plans, generally participants cannot borrow less that some predetermined amount - such as $1,000 - because smaller loan amounts are seen as an administrative burden. Also, IRS rules state that loans cannot exceed 50% of the current account balance, and not more than $50,000. Typically terms for loan repayment include payments at least quarterly and typically you can take up to five years to make payments.
The Last of the Easy Loans:
401(k) loans require little in the way of administration. There is no loan application, no credit report, no personal questions, and no justification. For many people this is the easiest and quickest source of borrowed money available. Also if you later default on a 401(k) loan, here's how a 401(k) loan default affects on your credit report.
401(k) Loan Costs:
There are costs with taking a loan from your 401(k). The most obvious is the loan processing fee, which is usually around $50 to $100. This may not sound like much but if you're borrowing a relatively modest sum, say $1,000, the fee can be 5% to 10% of the loan! For larger amounts, this is a less significant issue.
There are two hidden costs involved with 401(k) loans. First, when you take a loan you are reducing the balances in the plans investments. If those investments gain in value while the borrowed funds are out of your account, you are missing out on the returns. Of course the opposite is also true: if you took a loan and subsequently the investment funds in the plan decline in value, you would have avoided a loss. This is called the "opportunity cost" and it is difficult to know this for sure.
The other hidden cost is one that most folks are not aware of. Most folks understand that they are repaying their loan to their own account, which means they are paying themselves interest on the loan. It's almost never understood how repaying the principal and interest on your loan with after-tax dollars it treated when its time to take distributions. The money you repay into your pre-tax account will be taxed when you take distributions in retirement. So you are actually taxed twice on the portion of the balance that is made of the additional interest on the loan.
The biggest risk of borrowing from your 401(k) is that most plan rules require repayment within 30 to 90 days of leaving your employer. That's a disaster for someone who gets laid off or fired. If you don't have the money to pay off the loan it will be included in income as a taxable distribution. If you are under the age of 59 1/2 you'll owe a 10% penalty tax on top of applicable federal and state income taxes. If you don't have the money to pay the tax, the IRS may be able to collect the tax by deducting it from your remaining balance, virtually wiping out your retirement savings in the plan.
