Investopedia defines a 401(k)1 plan as "a qualified employer-sponsored retirement plan that eligible employees may make salary-deferral contributions to on a post-tax and/or pretax basis." While it is the employer's prerogative to offer loan options and other considerations, employees across the board frequently have the option to take out a loan on their 401(k). If you are considering taking out a 401(k) loan, what should you know?
The Basics of a 401(k) Loan
To apply for a 401(k) loan, you must contact your employer or plan administrator2. 401(k) loans generally have low interest rates compared to other types of loans. However, there are limitations to how much money you are allowed to withdraw. You are allowed to borrow up to $50,000 or half of the money in your account, whichever is less3. For example, an employee with $90,000 in his account could withdraw up to $45,000 for the loan, whereas an employee with $120,000 in his 401(k) could only withdraw up to $50,000.
Repayment Rules and Penalties
Generally speaking 401(k) loans are amortized over a 5-year period and repaid through regular payroll deductions. It is important to note that such deductions are after-tax deductions, and will therefore be counted as taxable income even though you will not be able to use such funds for personal or family needs.
While the majority of 401(k) loans are successfully repaid, the biggest cause of 401(k) loan defaults is the loss of employment. If you leave your job or are terminated for any reason, your 401(k) loan is typically due within 60 days4 from your last day at work. If your loan still has an unpaid balance after the 60 days, that balance is treated as a taxable distribution, and you will have until October 15th of the next year to pay the attendant taxes in full. If you are under the age of 55, you may also owe a 10% early withdrawal penalty to the IRS.
Credit Issues and Other Considerations
Defaulting on a 401(k) loan should not affect your credit score in any way. Your employer does not report 401(k) loan defaults to the credit bureaus. However, a default on your 401(k) loan will create a potentially heavy tax liability.
The IRS does allow for retirement plan administrators to extend a cure, or grace period to employees who are in danger of defaulting on their 401(k) loan. This grace period must end on or before the last day of the calendar quarter following the quarter in which the repayment installment was due.
In some situations the employee may be able to avoid the immediate tax consequences of a 401(k) loan default by rolling over5 an amount equivalent to the amount that would be treated as a taxable distribution to an IRA or a new employer's 401(k). However, this rollover would have to occur in the 60 days after discharge.
David Wray, president of the Profit Sharing/401(k) Council of America, advises employees who are considering a 401(k) loan to remember that should they default, it is likely that at least 40% of their money could go to the government (assuming a 25% federal tax, 5% state tax, and 10% penalty for early withdrawal).
Historically, 90% of workers have repaid 401(k) loans. However, taking out a 401(k) loan could potentially cut into your retirement savings, and prevent you from maximizing profits from the stock market. Defaulting can bring severe tax consequences. Therefore, it is important to carefully consider your current financial needs and level of job security before taking out a 401(k) loan. For more information and educational resources related to 401(k) issues, contact us today.