Many people have borrowed from their 401(k) plans in the recent economic downturn. Since only employed people may borrow from a 401(k) plan, you may wonder, "Why are employed people borrowing from their 401(k) plans if they still have jobs?" If your spouse loses a job, or your wages are frozen while expenses continue to rise, a 401(k) loan can be appealing.
Other pressing circumstances can also lead to 401(k) loans: education expenses, home foreclosures, a down-payment on a new home or un-reimbursed medical expenses. But does it make sense to tap into one’s retirement nest egg? If you have no access to a home equity loan or other savings, a 401(k) loan may simply be the best option.
Let’s review the federal regulations. You can borrow 50 percent of the vested account value up to a maximum of $50,000. For example, if the account value is $80,000, you can borrow up to $40,000. The repayment must be made by monthly deductions from ongoing wages for a period of no more than 5 years (60 months.) The interest rate is determined by the plan trustees (usually the employer) and is commonly a fixed rate of 1% above the prime rate of interest (currently 3.25%, so you might pay 4.25%). Good news, though! You are paying the interest to yourself because there is no middle-man. Interest is charged to make up for the opportunity cost lost by having the money out of the plan. It’s important to note that the loan proceeds are tax-free and the loan repayment is made with after-tax dollars.
If you terminate employment with an outstanding loan, you have three choices: (1) you can repay the loan upon termination. (2) You can transfer the loan to your new employer’s 401(k) plan, provided their plan document accepts transfers. (3) Or you can do nothing. In this ugly scenario, the outstanding balance becomes a taxable distribution and, if you’re under age 59 and a half, you will be subject to a 10 percent excise tax. Ouch! On an outstanding balance of, say, $30,000, you would pay $3,000 in excise tax AND the entire amount will be taxed at your annual income tax rate for the year.
Some employers do not permit employee loans. They reason that retirement money should be "sacrosanct" and not to be touched prior to retirement, or they simply don’t want to be burdened by an additional administrative issue. Unfortunately, denying participant loans may discourage some employees from contributing to their 401(k) plans because they feel they have no access to their money until many years in the future
Is it a GOOD idea to borrow from your retirement plan? Don’t take a cavalier attitude toward cracking your nest egg, but there are advantages. It makes sense to be your own banker at a low interest rate. It’s convenient because there is no credit check or long application form. Most plans allow you to borrow for any reason. It avoids over-extending credit card debt at exorbitant rates and creating a credit liability with a financial institution. You control the source of the money in your plan. The regulations allow for disciplined periodic repayment to reinstate the fund before you are ready to retire.
While borrowing from your 401(k) should not be your first choice for credit, it’s a viable option that you may want to consider if you have an unusual need and are usually financially disciplined.
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issue with a qualified tax advisor.
Bill Sheehy is owner of Sheehy Associates Inc. which specializes in Retirement Planning for individuals and corporate 401(k) plans. He is a Certified Financial Planner, a Certified Employee Benefits Specialist, a Certified Fund Specialist and a Chartered Retirement Plan Specialist. He can be reached at bill.sheehy@lpl.com or by calling 609-586-9100.
Sheehy Associates. 3812-B Quakerbridge Road, Suite 208, Hamilton. 609-586-9100. bill.sheehy@lpl.com
Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPC
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