1.Retirement Plan Loans: Are They Right for You? Is there anything your 401(k) plan can't do? It allows for tax-deferred earnings in traditional accounts and tax-free earnings in new Roth-style accounts. And traditional plans enable you to make contributions in pretax dollars, helping to reduce your taxable income. It even offers a menu of professionally managed investments from which to choose.
But there may be another feature of your 401(k) (or a similar retirement plan) that you haven't considered: You may actually be able to borrow money from your account. A survey published by the Employee Benefit Research Institute in 2004 revealed that more than 80% of those polled had retirement plans that offered loans.
2.Read the Rules First
The IRS currently allows you to borrow up to 50% of the total vested assets in your account, up to a maximum of $50,000. There may be loan minimums and certain other restrictions, depending on your plan's specific loan availability calculations.
Here's how a 401(k) loan works: The 401(k) sponsor (your employer) sells a portion of the plan investments from your account equal in value to the loan amount. If your 401(k) account is invested 70% in a stock mutual fund and 30% in a fixed-income mutual fund, the assets will be sold in the same proportions. The loan payments you make will be reinvested in whatever your then-current allocations are.
Money borrowed for other purposes, such as a new automobile, must generally be repaid within five years. However, you may be able to repay a loan taken to purchase a primary residence over a longer period. Specific terms of the loan -- frequency of payments and the interest rate -- will be determined by your company, which may allow you to make payments on a loan through payroll deduction. IRS rules require payments to be made at least quarterly.
Check the Rules Before You Borrow
* You can generally borrow up to half the vested amount in your account, but no more than $50,000.
* The loan must generally be paid back within five years. If the loan is used to purchase a house, you may have more time to repay the balance.
* If you leave the company before repaying the loan, the balance could be treated as distribution on which you'll be required to pay taxes and possibly a 10% early withdrawal penalty on all pretax contributions and earnings withdrawn.
3.Weigh the Pros ...
For some, the primary attraction of a 401(k) loan is the simplicity and privacy not generally associated with a bank or finance company. And unlike banks and other sources of loans, there is no need to fear being turned down for the money when borrowing from a 401(k) plan.
Another benefit may be competitive interest rates, which are generally tied to the prime rate. This interest is not tax deductible, however, and may actually "cost" you more than some other types of financing, such as a home equity loan which may allow you to deduct interest. The interest you pay on a plan loan goes directly into your 401(k) account and can then continue to grow tax deferred or tax free for your long-term needs.
4.... And Cons
Second, be aware of the potential opportunity costs, such as sacrificing tax-deferred compounding on the amount you borrow.
The effect of a retirement plan loan on your retirement assets is likely to depend on how much you borrow, how quickly you repay it, and your future contributions.
For instance, if you repay a loan relatively quickly, the long-term impact on your balance may be minimal. Also, if you continue contributions while you are repaying the loan, and remain in the plan long enough for potential tax-deferred investment gains to surpass the amount you borrowed, the effect may be insignificant over the long term.
In contrast, a loan may not be to your advantage if you leave your employer before repaying it. In this instance, any amount that has not been repaid prior to your departure is considered a taxable distribution. Even if you remain with your employer, if you stop contributing during the term of the loan, you forfeit the potential for tax-deferred investment gains during this period. If you remain with your employer and continue contributions, there is the possibility that a loan's interest rate could exceed your investment return, which could put a dent in your retirement savings as long as the loan remains outstanding.
5.Borrowing From Your 401(k): Should You or Shouldn't You?
The hypothetical example below illustrates the potential negative effect of stopping contributions when a loan is outstanding. Your circumstances may vary.
Participant's Salary: $40,000
Annual Salary Increase: 3%
Contribution Rate: 10% of salary
Annual Investment Return: 8%
Loan Taken in Year 15: $10,000
Interest Rate: 7.0%
Term: 10 Years
Total Time Period: 30 Years
Account Balance at End of 30-Year Period Percentage of No-Loan Balance
No Loan $659,698 100.0%
Loan Taken, Contributions Continued $658,377 99.8%
Loan Taken, Contributions Suspended $489,356 74.2%
6.Make the Most of Your Retirement Plan
The primary reason to invest in an employer-sponsored qualified retirement plan, such as a 401(k) plan, is to pursue your long-term financial goals. Remember, the earlier you invest and the longer you stay invested, the more you'll potentially benefit from tax-deferred or tax-free compounding.
But if you've accumulated assets in your account and you're in need of a loan, a retirement plan could be a source of funds.
Summary
* Under IRS rules, 401(k) participants can borrow half the amount in their account, up to a maximum of $50,000.
* Loans generally must be repaid within five years.
* Simplicity and privacy are considered benefits of 401(k) plan loans. Interest rates are also generally competitive.
* Participants who leave their company before fully repaying a loan could end up owing federal income taxes and a 10% early withdrawal penalty on the balance.
* Many companies charge fees for 401(k) plan loans.
Checklist
* Carefully read all of the rules governing loans from your plan.
* Consider whether you could, if necessary, afford to repay the full amount of your loan within 30 days of leaving the company.
* Instead of accessing money earmarked for retirement, ask your bank or credit union about a personal loan or a tax-deductible home equity loan.
* If you do take a loan, be sure to make all of your payments on time.
