Client Tip for May 2015: 401k Loans
401k loans have become a very popular means to access cash quickly. Approximately 30% of all employees who have the ability to take out a 401k loan have done so.
Employers must amend their plans to allow for 401k loans by the participants. Many small businesses have not added this feature to their plan due to the costs and many guidelines required to administer the loans. Restrictions can be placed on what the loans can be used for such as education costs, medical bills, purchase of a home, etc.
If a participant has had no other plan loan in the 12-month period ending on the day before you apply for a loan, they are usually allowed to borrow up to 50% of their vested account balance to a maximum of $50,000. Notwithstanding this rule, a minimum of $10,000 may be borrowed (provided that there is adequate outside security for such a loan). If the participant had another plan loan in the last 12-month period they will be limited to 50% of their vested account balance, or $50,000, minus the outstanding loan balance in the preceding 12-month period, whichever is less.
Because of the cost, many plans will also set a minimum amount (often $1,000) and restrict the number of loans any participant may have outstanding at any one time.
Loan payments are generally deducted from payroll checks and, if the participant is married, they may need their spouse to consent to the loan.
Some of the advantages to 401k loans are:
- There are no credit checks or long forms to complete.
- Interest rates are usually 1% or 2% above prime.
- The interest is going back into your plan.
Some of the disadvantages are:
- You may be taking funds out of accounts that were earning a higher rate of return than the interest you are paying.
- You may have to pay a fee to get the loan.
- If you quit work or change employers, you will be required to pay the loan back. If not, it will be shown as a distribution from the plan, which is subject to income taxes and possibly a 10% early withdrawal penalty if you are not at least 59½.
- The loan must be paid back over five years, although this can be extended for a home purchase.
Much consideration should be given before taking out a 401k loan. Before taking out a 401k loan, be sure to weigh all your options. It should be used as a last resort.