401(k)s offer some pretty cool features for saving including high contribution limits and Roth 401(k) options. And if your company enabled the feature, your plan also offers access to your 401(k) savings via a 401(k) loan just in case of an emergency. 401(k) loans give you access to your account funds without any tax penalty and can help you get through a tough time. Yes, 401(k) loans can be good in a pinch, but as you’ll quickly see, there are some important items to consider before you decide to do so. So, here’s how it works and the potholes to avoid.
You can get a loan from your 401(k) for up to 50% of your vested account balances (your personal contributions plus any vested matching or profit sharing from your company) with a cap of $50,000. You pay yourself back at a rate of Prime plus 1% (the Prime rate is the interest rate that commercial banks charge their most creditworthy corporate customers). That’s a pretty good rate.
Loans are put on a schedule to be paid back over a 5-year period. Typically, payments will be automatically deducted from payroll. There is one exception, which is a residential loan. These can be paid back over 30 years. Most plans restrict how many loans you can have outstanding to one or two at any one time. The charge to take a 401(k) loan is generally pretty nominal.
Your retirement savings will likely suffer. The money you take out for a loan will not have the opportunity to grow with your investments. This means it will probably take longer to reach your retirement savings' goal. You pay the loan back like any loan with your after-tax income and when you do withdraw the monies in retirement, it will be taxed again. Yet, the monies do grow tax-deferred once back in your 401(k) account until used in retirement.
If you quit or lose your job, the outstanding 401(k) loan amount is due fairly quickly — typically within 30-60 days. If you do not pay off the balance within this time, the IRS treats this as a 401(k) distribution, and you will be taxed at your current tax rate plus a 10% early distribution penalty on top of it if you are younger than 59 ½ years of age. Ouch! Also, if you do not make payments to your 401(k) loan for 90 days, again the IRS will be unhappy and treat this as a 401(k) distribution. And that means it will be taxed at your current tax rate plus the 10% penalty.
Our Take on 401(k) loans
Our vision is to lead Americans to save — and loans are not a savings tool. If you are considering a loan given your personal situation, make sure you consider your company’s soundness and your job security. Having to come up with a big lump sum to pay back the loan if you were to be out a job isn’t easy. Or worse, being hit with taxes and penalties can be big hits to your savings and finances. We always suggest starting with your bank and then consider your other options before tapping your 401(k). 401(k) loans do offer added security, convenience, and low rates, but the pitfalls that exist make them an emergency source of funds. If you do take a loan, see if you can pay the loan early, so you lower your risk to the Ugly and stay on track to meet your long-term goals.
This material is intended only as general information for your convenience, and should not in any way be construed as investment or
tax advice by ShareBuilder. You should consult with your tax advisor regarding any specific tax strategies.