401(k) Loans – What you need to know
Recently I’ve been getting calls from people considering the loan option from their 401(k). They knew their plan offered a loan and wanted confirmation that it wasn’t a big deal to use this feature. With each call I explained the long-term effect taking a loan would have on their account; many were unaware of what this event could do to the long-term potential of their retirement savings.
Before considering a loan, please review the information below. I will explain how loans are calculated, how payments are made, and factors people typically don’t think of when they make this decision.
What types of loans are there?
401(k) plans are not required to offer loans, but if they do, there are typically two types of loans offered, with only slight differences between the two loan types.
- General loan – can be taken for any reason and needs to be paid back in 5 years.
- Principle residence loan – repayment terms are typically extended to the maximum of 10 years and your employer may require documentation that shows the funds are being put towards the purchase of a primary residence.
How much can you take out and how is it calculated?
Legally you can take out to the lesser of $50,000 or 50% of your vested account balance. Here are examples showing this:
Ex) If Bob hasn’t taken a loan in the last 12 months and had a vested account balance of $195,000, he could take out the maximum of $50,000. ($195,000 X 50% = $97,500; 50% of Bob’s balance is > $50,000 the max allowed by law.)
Ex) Cindy has a vested account balance of $24,000 and hasn’t taken a loan from her 401k before. The maximum she could take out is $12,000. Example – $12k (50% of balance) is less than $50k the max allowed by law
There is another stipulation to the rule. If you took out a loan within the last 12 months, or have an outstanding loan, the maximum amount you can take out is the lesser of 50% of your vested account balance or $50,000 minus the highest outstanding loan balance from the last 12 months. Here is example:
Ex) Henry has a vested account balance of $142,000 but took out a $10,000 loan 8 months ago, which he recently paid off in full. He now wants to take out a loan for $50,000. Unfortunately he can only take out $40,000. Since he had an outstanding loan in the last 12 months the maximum he can take out is the lesser of 50% of his vested balance ($142,000 X 50% = $71,000) or $50,000 minus his highest outstanding loan balance in the last 12 months ($50,000 – $10,000 = $40,000).
Please note, some plans will put a limit on how many loans you can take out over a certain time or have outstanding at a time. In addition, some plans will not allow you to take loans immediately after paying a previous one off.
How are loans funded?
One common misconception is that your employer is lending you money and you are paying them back. That is not the case. You’re in fact borrowing from yourself, so you actually have to sell off funds from your 401(k) account. In most cases plans will sell off funds proportionally to keep your percentage allocations the same.
How do I pay back the loan and how are payments calculated?
Since you are borrowing from yourself, you will have to pay yourself back. This is done through after tax deductions from your paychecks. To figure out how much is taken out per paycheck you need to know:
- How much you’re taking out
- How long you’re taking to pay it back
- How often you’re paid
- What is the interest rate
Your employer will take this information and plug it into a calculator, similar to this one to find out how much should be taken out per paycheck. Here is an example:
- How much you’re taking out: $50,000
- How long you’re taking to pay it back: 4 years (48 months)
- How often you’re paid: twice a month (24 payments in a year)
- What is the interest rate 4.25% (Prime rate of 3.25% plus 1%)
Each loan payment from your paycheck would be: $566.82
Most plans will allow you to pay the loan off early. Typically it has to be a lump sum instead of partial pre-payments. So for the example above, you would have to pay the full remainder of the $50,000 balance rather than partial payments of $566.82.
So what’s the big deal on taking a loan? I’m borrowing from myself.
There are a number of reasons against taking a loan from your 401(k) if you don’t have to. I believe this should only be used in a worst case scenario or when all other options have been exhausted. The reasons behind this include:
- The loss of growth potential of the money taken out of the plan to fund the loan. Even if the market is down and the interest rate you’d be paying yourself back at seems appealing, remember, you’re paying yourself the interest rate back so you aren’t really making any money off your holdings.
- If you sell off shares to fund the loan while the market is down, you could end up purchasing fewer shares if the market rebounds while loan payments are made.
- You pay yourself back with after-tax money. Loan payments are deducted after taxes have been taken out. However, since pre-tax money is usually used to fund a loan the payments are put back into your 401(k) as pre-tax funds. So because of this, when you take the money out later, you have to pay taxes on it again. You basically get stuck paying taxes twice on however much you took out for a loan. Nobody likes pay taxes so why do it twice? (Some plans will permit you to use after tax money to fund a loan.)
- Since you have to pay back the loan with deductions from your paycheck, you might be tempted to reduce or eliminate your contributions. This could mean missing out on matching contributions and compounding interest.
- Typically there is a fee associated with the loan origination.
- In the event that you left work or were let go, you might be required to pay off the loan in a lump sum or face the potential of the loan going into default. Default results in a taxable event. Here is an article discussing the potential impact of having a loan after leaving employment.
- Unlike interest payments for home loans being tax deductable, the interest payments from a 401(k) loan are not.
I have to stress again that I believe taking a loan or any type of cash distribution from your 401(k) should only be done as a last resort. It shouldn’t be for a new boat or vacation, which I have seen happen. Taking a loan can have a long lasting effect on your retirement savings and put you in a bind down the road.
As always, if you have any questions in regards to loans or any other questions please do not hesitate to contact us at 877.627.8401 or info@smart401k.com.
Jeff Studebaker
Smart401k Adviser
About Smart401k
Smart401k is a Web-based investment adviser providing unbiased advice to help employees invest in their employer-sponsored retirement plans. Smart401k provides service to almost 11,000 clients who collectively have more than $1.5 billion in assets. Individuals receive personalized investment recommendations based on the funds in their plan and support of professional investment advisers available to answer all investment questions. Based in Overland Park, KS, Smart401k can be found at Smart401k.com.
