Ideally, everyone would have a savings account or emergency fund to draw on when they face unplanned expenses. But in the real world, it’s common for cash flow to fall short of one’s needs from time-to-time. For many people, their largest financial asset is their retirement savings in a 401(k) account.
401(k) LoansGerard with Ubiquity Retirement + Savings discusses the implications of borrowing from your 401(k) plan. Want to learn more? Subscribe to our channel and visit http://www.myubiquity.com to learn more. Or visit us on social media: https://www.facebook.com/ubiquitysavings https://twitter.com/ubiquitysavings https://www.linkedin.com/company/ubiq...
To help individuals manage the challenge of both saving enough for retirement and setting aside money for unplanned expenses, most 401(k) plans allow the business owner and employees to take loans from their 401(k) accounts. When the 401(k) loan is repaid to the plan account, with interest, an individual can stay on track with their retirement savings even while addressing short-term cash needs. But loans that are not repaid can put retirement savings at risk.
401(k) Loan Rules
Maximum 401(k) loan
The maximum amount that you may take as a 401(k) loan is generally 50% of your vested account balance, or $50,000, whichever is less. If 50% of your vested account balance is less than $10,000, you may borrow up to $10,000 if your plan allows it.
All 401(k) plan loans must meet the following requirements:
Each loan must be established under a written loan agreement.
The business owner must set a commercially reasonable interest rate for plan loans.
A loan cannot exceed the maximum permitted amount.
A loan must be repaid within a five-year term (unless used for the purchase of a principal residence).
Loan repayments must be made at least quarterly and in substantially equal payments that include principal and interest.
The business owner has some flexibility in designing a loan program for their 401(k). For example, they may choose to set a limit on the number of loans an employee may take at one time or within one year or set a minimum dollar amount for a loan.
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Reasons to borrow from your 401(k)
Although general financial wisdom tells us we shouldn’t borrow against our future, there are some benefits to borrowing from your 401(k).
With a loan from a commercial lender such as a bank, the interest on the loan is the price you pay to borrow the bank’s money. With a 401(k) loan, you pay the interest on the loan out of your own pocket and into your own 401(k) account.
The interest rate on a 401(k) loan may be lower than what you could obtain through a commercial lender, a line of credit, or a credit card, making the loan payments more affordable.
There are generally no qualifying requirements for taking a 401(k) loan, which can help employees who may not qualify for a commercial loan based on their credit history or current financial status.
The 401(k) loan application process is generally easier and faster than going through a commercial lender and does not go on your credit report.
If you are taking a loan to buy a home, you can have up to 10 years to repay the loan with interest.
Loan payments are generally deducted from your paycheck, making repayment easy and consistent.
If you are in the armed forces, your loan repayments may be suspended while you are on active duty and your loan term may be extended.
Possible consequences if you borrow from your 401(k)
Although paying yourself interest on money you borrow from yourself sounds like a win-win, there are risks associated with borrowing from your retirement savings that may make you want to think twice about taking a 401(k) loan.
The money you pull out of your account will not be invested until you pay it back. If the investment gains in your 401(k) account are greater than the interest paid to your account, you will be missing out on that investment growth.
If you are taking a loan to pay off other debt or because you are having a hard time meeting your living expenses, you may not have the means to both repay the loan and continue saving for retirement.
If you leave your job whether voluntarily or otherwise, you may be required to repay any outstanding loan, generally within 60 days.
If you cannot repay a 401(k) loan or otherwise break the rules of the loan terms, in addition to reducing your retirement savings, the loan will be treated as taxable income in the year you are unable to pay. You will also be subject to a 10% early distribution tax on the taxable income if you are younger than age 59½. For example, if you leave your employer at age 35 and cannot pay your outstanding loan balance of $10,000, you will have to include $10,000 in your taxable income for the year and pay a $1,000 early distribution tax.
Do your research
Sometimes the immediate need for money outweighs the potential risk of a 401(k) loan. But before you decide to borrow against your 401(k), be sure to consider your alternatives.
Compare the fees and interest rates for a 401(k) loan and commercial loans.
Explore other financial resources that may be available to you (e.g., selling an asset, reducing monthly expenses/luxuries).
Consult with a financial planner or tax advisor who can help you decide if a 401(k) loan is the best option for you.
If you are a small business owner and need a 401(k) plan for yourself and your company, only Ubiquity offers flat-fee plans plus free expert advice. We’ll fully customize your 401(k) to meet the specific needs of your small business.
Setting up a 401(k) can be complicated. Only Ubiquity gives small business owners access to 401(k) experts in addition to industry leading low flat-fees. Each sales expert has over a decade of experience assisting business owners in 401(k) plan design. Take advantage of this free benefit.