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Borrowing Early from a 401(k): Pros and Cons

Is borrowing early from a 401(k) plan the right move if you or an employee is in a cash crunch? Barbara Weltman explains some rules and regulations around doing this, and why making this decision shouldn't be taken lightly.
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A 401(k) account could be a significant asset and a tempting source of funds to pay for something you need. Most 401(k) plans today allow participants to borrow from their accounts, with funds repaid in level amounts over a period of not more than five years (longer if they are used to buy a principal residence).

Employers are not their employees’ financial advisors. Nonetheless, if you offer a 401(k) plan at your business, consider the following information that may help you and your employees better understand the rules and regulations around borrowing early from a retirement plan.

Benefits of borrowing from a 401(k) plan

It is relatively easy to arrange a loan when borrowing from a 401(k) account. You don't have to show a credit score, provide a reason for needing the loan, or complete a lengthy loan application.

Additionally, the interest rate on borrowing from the plan is low. While the plan sets its rate and it's required to be a "market rate," it is usually lower than a rate you'd pay for most commercial borrowing. For example, if the plan has a rate of prime plus 1 percentage point, the rate on July 1, 2018, would be 6% (5% prime + 1%). Unlike a traditional loan, the interest charged in a 401(k) loan is credited back to your account.

Downfalls of obtaining a loan from a 401(k)

Just because the ability to obtain a loan from your 401(k) is quick and easy should not lead you to draw on your account without serious consideration. There are many factors weighing against borrowing from a 401(k) account:

  1. Borrowing can undermine your retirement savings. The purpose of the 401(k) is to build a nest egg that can provide financial security in retirement. When you take a loan, you lose the potential investment returns on that money. Though you must pay interest on the funds and that interest is credited to your account, as noted earlier, the interest is modest compared with the returns you likely would enjoy through the invested funds. And, in some plans, the loan is taken equally from each investment held in the account. That means you may be unable to take the loan solely from a low-yielding investment in the 401(k).
  2. There could be a bar to additional contributions until the loan has been repaid. A plan is allowed to set this rule, although not all do so. In other words, some plans opt to apply annual contributions to the loan balance. If so, you not only lose out on potential investment earnings on the contributions, but also on employer contributions to your account if the company has a matching program.
  3. Those who leave the company with a loan outstanding — whether it’s a resignation or a termination — must repay the loan within a period set by the company. If not, the outstanding balance is treated as a taxable distribution.

If you're younger than age 59½, you may also be subject to a 10 percent penalty. You can avoid this by paying back the money to the plan within the time limit or depositing the unpaid balance in an IRA no later than the due date of your income tax return (including extensions) for the year that it would otherwise be taxable. This is a new option that applies after 2017.

  1. Another drawback is the amount of the loan that can be taken. You can't borrow all of the funds in your account. The tax law limits borrowing to the lesser of 50 percent of your vested account balance or $50,000 (a special rule applies if your account balance is under $20,000). As part of tax reform, qualified hurricane distribution relief is available to eligible victims for any 2016 presidentially declared disaster event (such as Hurricanes Harvey, Irma, and Maria and the California wildfires in 2017). Also, you may have to take more than you need because the plan may have a loan floor (e.g., minimum of $1,000).
  2. Finally, there may be fees to set up the loan. In most cases, you can't deduct the interest you pay on it.

While it may be tempting to tap into a 401(k) plan, it runs counter to the purpose of having the account. It is not advisable to use the funds in an account for purposes other than retirement savings, except in extreme situations. In other words, only consider taking a loan if you experience an extreme unforeseen emergency. A tax or financial advisor can help you and your employees make an educated decision.

barbara weltman
Barbara Weltman is a tax and business attorney and the author of J.K. Lasser's Tax Deductions for Small Business as well as 25 other small business books.
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This website contains articles posted for informational and educational value. Paychex is not responsible for information contained within any of these materials. Any opinions expressed within materials are not necessarily the opinion of, or supported by, Paychex. The information in these materials should not be considered legal or accounting advice, and it should not substitute for legal, accounting, and other professional advice where the facts and circumstances warrant.

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