Does Your 401(k) Plan Allow Loans? | Details You Must Know

Does Your 401(k) Plan Allow Loans?

In the spectrum of employee benefits, 401(k) savings plans are one of the most widely used ways to help employees save for retirement.  401(k) plans (see: different types of 401k plans) are meant to be long term savings vehicles, and the IRS has many rules in place for discouraging use of this money for short term needs.  But it’s no secret in today’s economy that employees are turning to their 401(k) accounts for some relief from mounting debt.  There are limited circumstances where an employee must show a financial hardship in order to access their money sooner than retirement.  But taking a hardship withdrawal also means that the employee may have to pay a 10% early withdrawal tax penalty if they are under age 59-1/2, and the employee is suspended from contributing any more money for another six months.  This should be the absolute last resort because it really hinders the goal of saving enough money for retirement.

But what about loans?  What if an employee is in a bind, and wants to borrow money from their 401(k)?  Although not the ideal place to borrow money, 401(k) loans aren’t as damaging to the employee’s retirement nest egg as hardship withdrawals because:

  1. There are no income taxes on the loan, as long as they pay the money back.
  2. There is no 10% early withdrawal penalty, as long as they pay the money back.
  3. Unless your plan says otherwise, there is no suspension of contributions.  The employee can continue to make salary deferrals and contribute to their 401(k) account at the same time they are repaying their loan.
  4. The process for obtaining a 401(k) loan is quicker and the cost is cheaper than applying for a bank loan.
  5. The employee is paying themselves back with interest.
  6. Normally the employee can borrow up to 50% of their vested account balance, up to $50,000.

When an employee takes a loan on their 401(k) money, they essentially are paying themselves back at an interest rate that’s outlined in the plan document.  A common interest rate used is the Wall Street Journal Prime Rate or Prime + 1% or 2%.  With the Prime Rate being so low these days (3.25% as of right now), 401(k) loans are a popular choice among employees to access their money.

There are definitely some drawbacks and limitations that employees need to be made aware of before taking a loan:

  1. Taking a loan reduces the money in your account.  Therefore this reduces the ability for your account balance to grow, and this loan money will miss out on investment gains.
  2. If your employment terminates before you are able to pay back the entire loan, the remainder of the unpaid loan does become taxable, and subject to the 10% penalty if under age 59-1/2 .
  3. The maximum time to repay a loan is five years.  If you are borrowing to purchase a home, the term loan can be extended.
  4. If you are borrowing to purchase a home, the interest you pay is not tax deductible.
  5. The loan is repaid with after-tax payroll deductions.  So your take home pay will be reduced by the actual amount of your loan repayment.

If you don’t currently allow for loans and are considering adding them to your 401(k) plan, there may be additional expenses and will be additional administration for each loan request.  The administration steps go something like this:

  • Step 1:  The employee completes a loan request form.  This can either be a piece of paper, or online if your 401(k) provider has a website that allows for this.
  • Step 2:  The plan administrator normally approves the request before submitting it to the 401(k) provider.  I can’t speak for all 401(k) providers, but nowadays, the loan processing time should take less than a week.
  • Step 3:  Upon receiving the loan request, the 401(k) provider will create a loan amortization schedule and send the employee a check (or wire the money) along with their repayment schedule.  Sometimes the employee is required to sign a separate promissory note, sometimes the employee agrees to the terms of the loan simply by endorsing the back of the check.
  • Step 4:  The 401(k) provider will also send a copy of the loan repayment schedule to the plan administrator.
  • Step 5:  This employee’s loan repayment will need to be set up as an after-tax deduction in your payroll system.   If your payroll software has the ability to track a “lifetime limit” or “goal, the deduction will automatically turn off once it has reached the limit.
  • Step 6:  The loan repayment will need to be remitted to the 401(k) provider each pay, along with salary deferrals and company contributions.  It’s very important to make sure these repayments get submitted, or else the loan could go into default.

Be sure to keep all documentation for each employee’s loan request, as you will need this if/when your 401(k) plan is audited.

It’s important for both the plan administrator and employees to be aware of the caveats of 401(k) loans.  Although borrowing from a 401(k) should not be encouraged, it could be a better alternative for the employee than an early withdrawal.

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