401k Plan Loans: Are They Right For You?

This is the third in a three-part series on 401k retirement plans. In this article, we examine the value of a 401k Loan Plan.

There are at least 18 factors that need to be considered when deciding whether a client should take a 401k loan. This excerpted article taken from the July 2019 Journal of Financial Planning Professionals offers a brief overview of the considerations, pro and con.

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When clients look to borrow funds, there are a variety of alternatives, including their 401k plan. Many financial planners believe that a properly handled 401k loan might be the least costly source of funds for their clients. To best understand how to advise clients on the benefits of such a loan, the rules that pertain to borrowing from a qualified 401k Plan must first be examined.

Plan Loan Rules

A plan loan allows individuals to borrow from their vested retirement account, without taxation on loaned funds. Not every 401k plan allows for loans and even when the plan is designed to include a loan provision, the plan administrator can restrict loans to specified circumstances (e.g. loans may only be taken in similar circumstances to the requirements for a hardship withdrawal.)

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There is a ceiling on the amount that can be borrowed from a 401(k) plan. Plan participants can borrow a maximum amount equal to the lesser of $50,000 or half of the vested account balance. Many plans are also designed so that clients cannot take a loan of under $1,000. The loan must also charge a reasonable rate of interest, providing comparable return with rates being charged by most lending institutions that provide similar loans.

Plan loans must be paid back using level amortization (usually in equal monthly installments) and within 5 years. If a client leaves their job, they have until October of the following year to put the money back into the 401(k) with their new employer. If the client were to default on the loan, any of the benefits payable are reduced by the outstanding balance, which is treated as a taxable contribution of the amount that was defaulted.

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For a client who needs to borrow, the plan loan has several attractive qualities in comparison to commercial alternatives.

  1. Simple access, typically through a website provided either by the plan sponsor or the investment company managing the plan funds.
  2. No need to verify eligibility for the loan.
  3. No paperwork needed to verify that the client possesses sufficient collateral for the loan.
  4. Funds often quickly available.
  5. Generally lower transaction costs, allowing the client to keep more of what is borrowed.

Those reasons aside, a commercial loan may be preferable to a loan from a qualified plan center, for a number of reasons.

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  1. The amount of money that can be borrowed from a plan loan is generally restricted to the lesser of $50,000 or one-half the vested account balance. Commercial loans can exceed such limitations if the client’s needs warrant such.
  2. A plan loan that is not being used to purchase a principal residence must be paid off in 5 years, as opposed to commercial loans that can offer smaller repayment amounts over a longer payback period.
  3. A plan loan revolves around the continued employment of the client with the employee. Eighty six percent of those who leave their job default on their loan, which can result in unwanted tax consequences, including imposition of a penalty tax. Conversely, leaving a job has no adverse impact on a commercial loan.

An additional concern of a plan loan is the opportunity cost of being out of the market.Market timing can be a key determinant of the desirability of a plan loan in losing out on the opportunity for market gains.

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Finally, there is a question of a double tax issue on plan loans, based on the facts that loan repayments are not deductible (tax 1) and they are taxable on withdrawal (tax 2).

However, financial researchers, Geng Li and Paul Smith, have partially debunked this thinking by pointing out that loan proceeds are coming from pretax 401k dollars, which are not taxed when the loan is distributed.

Repaying the loan with after-tax dollars is merely replacing the initial tax savings that were available to the before-tax 401k contribution.

Further in their research, Li and Smith used a mathematical model to calculate the cost differentials between a plan and commercial loan and determined them to be negligible, suggesting that plan loans can be a desirable choice for the client.

For more information on 401k loans contact Angela Hall at GCW Capital Group 716.256.1682 or ahall@gcwcapitalgroup.com