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401(k) Loans: When you need your money NOW

Ideally, you will never touch your retirement funds, allowing them to grow continuously until you retire. But we don't live in an ideal world! In case of emergency, the funds in your 401(k) may be available to you in the form of a Loan.

One of the benefits of many 401(k) plans is being able to borrow against your retirement savings in times of need. Currently, about 20 percent of employees eligible for a plan loan have one, and the average outstanding loan balance is approximately $6,300. If your plan has a loan program you have the security of knowing that your money is available "just in case," which means you can comfortably make a sizable commitment to retirement savings in your plan. Also, if you need money from your plan because of a financial emergency and your plan has a loan program you will be required in most cases to take a loan first. Now, let's assume you have an unexpected crisis and you need your money -- what should you know?

Loan Basics

  • Plans typically allow you to borrow 50 percent of the amount in your plan, up to $50,000.
  • In nearly all cases you must repay the loan in 60 equal monthly payment over a five-year repayment period. The one exception is for a loan that is a mortgage for your primary residence, then the repayment period may be longer.
  • The interest rate you pay will be determined on the day you take the loan. While interest rates vary by plan, the rate most often used is what is termed the "prime rate" plus one percent. You can find the current "prime rate" in the business section of your newspaper.
  • In nearly all cases you will repay your loan through payroll deduction. Only a few companies will allow you to repay in any other way.
  • You can always repay your loan at any time with no penalties.
  • Many plans will permit you to have more than one plan loan.
  • Plan loans usually have a minimum amount requirement, typically $1,000.

Pros and Cons

Plan loans are convenient, but they are not always the right solution. Consider both the positives and negatives to determine if a plan loan is best for you. And always compare the overall cost of a plan loan with other possible loans.

Plan Loan Advantages
Less Paperwork: No credit checks or long credit application forms. You may be able to obtain a plan loan simply by visiting your benefits office, calling your plan's 800 number or going online.
 
No Restrictions: Most plans let you borrow for any reason. Check your plan.
 
Fast: You could receive a loan in mere days, depending on how often your plan processes transactions.
 
Good Rates: The prime rate is the interest rate that banks charge their best customers. The prime rate plus one percent is a very good rate of interest for an individual borrower.
 
Higher Return: The rate of repayment for your loan may be greater than the rate of return you were receiving on the fixed investments in your plan. For example, if you were to replace assets from your money market fund paying four percent with your plan loan paying seven percent you would be earning a higher rate of return.
 
Plan Loan Disadvantages
Loan Default: The consequences of a plan loan default are different than for the default of other types of loans. If you fail to repay the plan loan, you will have to pay both regular federal and state income taxes and if you are under age 59 1/2 an additional federal income tax equal to 10 percent of the outstanding balance.
 
Fees: 70 percent of all plans charge a one-time loan fee, ranging from $3 to $100. Another 25 percent of plans also charge a yearly service fee, ranging from $3 to $75.
 
Alters Financial Plan: You've done the work to determine your retirement goal and pick the right investment mix. But when you take a plan loan, money must be removed from your plan investments. If plan loan amounts must be taken money from your equity investments this could diminish your overall plan return.
 
Market Cost: Cash for your loan from selling shares from your stock funds when the market is down, may force you to sell your stock at a loss reducing your long term plan investment return.
 
Spousal Consent: Some plans require that you get your spouse's permission for a plan loan.
 
Lower Returns: The rate of repayment for your loan may be lower than the rate of return you were receiving from the investments in stock in your plan. For example, if you were to replace assets from your diversified equity fund returning ten percent with your plan loan paying seven percent you would be earning a lower rate of return.

There is a popular misconception that paying back a plan loan is like "paying yourself." Unfortunately, this is not true. When you take a loan from your plan, you are withdrawing money from your account balance and replacing it with an IOU. That IOU continues to generate interest from your repayments, but generates no special investment return.

In a sense, all fixed investments are a kind of loan. You are lending money to the government or a corporation through the stable value, money market or bond funds in your plan. However, the return (or interest) generated from these loans comes from a borrowing party. When you loan yourself the money you are simply replacing the interest you would already be receiving with interest payments from yourself.

Plan Loans and Your Investments

To preserve your asset allocation plan when taking a plan loan, you should withdraw the funds for the loan from the fixed income allocation side of your portfolio. Let's assume you have 50 percent of your money invested in equities and 50 percent invested in fixed income. When you borrow 50 percent of the money in your plan, you want to take the funds entirely from the fixed income side and maintain all the equities. Some plans will ask you to make that determination, others will reduce all of your investments proportionally by the amount of your plan loan. In that event, you need to go back and rebalance the remaining investments to the proper equity and fixed allocation ratios. In others words be sure to take money for your plan loan from your lowest returning investment option.

Warning: Don't Default On Your Loan

This is crucial: if you leave your current employer, have no outstanding plan loans. Whether you find a new position or you are laid off, in most cases your plan loan will come due when employment ends. You will be given a limited amount of time to pay off your loan, and if you cannot repay it will be placed in default. "In default" means your employer will report to the government that you were unable to pay the loan, and the government will then treat the defaulted amount of your loan as a distribution. This most likely will lead to regular taxes on the defaulted amount plus for those under 59 1/2 the ten percent additional federal income tax penalty. Depending on your tax bracket and the tax rate of your state, you could be forced to pay the government as much as half of the defaulted amount. Some people take a cash advance on their credit card to pay off their plan loan when they change jobs, because 18 percent interest is still better than a 50 percent tax liability.