According to the Investment Company Institute as of the end of June 2010, approximately 17.5% of defined benefit plan participants are carrying an outstanding loan balance.1 As unemployment continues to be an issue in most communities, what should you as a 401k participant think about before taking a loan?
Generally speaking there are two ways in which you can take money out of your 401k: a loan and hardship withdrawal. In order to take a loan however, it must be an option available through the plan document. If the plan allows for loans, as a participant, you may borrow up to 50% of your vested account balance up to a maximum of $50,000.2 If you had another plan loan in the last 12 month period, you are often limited to 50% of your vested account balance, or $50,000, minus the outstanding loan balance in the preceding 12-month period, whichever is less. Also depending on the plan, there may be a minimum amount that you must borrow.
What if you quit, are laid off or fired? If any of these events happen before you have paid the amount you withdrew back, you will have to pay the loan in its entirety immediately. If you are financially unable to pay it back, the IRS then treats it as an early distribution and you will be required to pay taxes plus a 10% penalty if you are under 59 ½. In general, even if you remain at your job, the loan has to be repaid with interest which is in essence paying interest to you. However you are losing the benefit of having your money tax sheltered, the monthly amount you repay is taken from your paycheck with after-tax dollars. When you retire you have to pay taxes once again on the withdrawals, a double hit with taxes.
What if you file for bankruptcy? Generally filing for bankruptcy does not remove a 401k loan; however always consult an experienced attorney for the specifics.
Finally, know the rules: Be educated on how much time is allowed for paying the loan back, interest rates you are charged, and whether or not you can continue to contribute to your retirement account while carrying an outstanding loan. Usually the loan must be repaid within 5 years, unless the loan is being used to buy your main home. In addition, some 401k plans also require that your spouse consent to your loan.
After consulting with your financial advisor and accountant, if you do decide that it is your only and best option, determine a plan to repay the loan and stick to it. Please speak to an attorney prior to making any legal decisions and tax advisor prior to making any tax decisions.
2 IRS.gov 401(k) Resource Guide – Plan Sponsors – General Distribution Rules