While you don’t necessarily want to borrow against your 401(k) plan, there might be some situations when you would consider it.
401(k) Plan Loans
The Internal Revenue Service (“IRS”) allows employers to allow employees to borrow against their 401(k) plan. For an employee to borrow against his 401(k) plan this loan provision must in the plan document. The maximum that can be borrowed is one-half the account value, not to exceed $50,000. The employee must pay this loan back over the course of the next five years. The interest rate charged is determined by the plan. Generally the rate is the Prime Rate plus 1% or 2%. Currently the Prime Rate is 3.25% so 401(k) loan might cost 4.25% or even 5.25%. The loan is paid back through payroll tax deductions. These deductions are after-tax.
Potential Borrowing Situations
As mentioned above, borrowing against your 401(k) plan might not be ideal. With that said, life isn’t always ideal. Frankly, you just may need the money. And there may not be any other sources to borrow from.
Other situations we have seen are to pay for a portion of college. College, as I’m sure you are aware, is expensive. Borrowing against your 401(k) plan is fairly easy and the interest rate is very low. Finally, we have seen clients use this to pay off a small mortgage. In their particular case, the interest rate was significantly less than what they were currently paying. With the 401(k) plan loan, they didn’t have to go to a bank and get involved with all of the paperwork and potential fees of refinancing their home. This was a much quicker and easier way to access the loan.
Borrowing money against your 401(k) loan is not perfect. First, the interest on this loan is not income tax deductible. This makes the cost of borrowing higher. Second, if you leave your employer, either voluntarily or involuntarily, you will need to repay the outstanding 401(k) loan balance. If you can’t repay this loan, the former employer must issue you a 1099-R and you will have to report this as taxable income. Additionally, if you are under age 59 1/2 there will be a 10% premature distribution penalty. Either way, there will be no cash available to direct towards withholding. In other words, when you receive this 1099-R it will be fully taxable and there will have been no withholding.
Have you borrowed against your 401(k) plan?
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You then must repay the money you have accessed under rules designed to restore your 401(k) plan to approximately its original state, as if the transaction had not occurred. Another confusing concept in these transactions is the term “ interest .” Any interest charged on the outstanding loan balance is repaid by the participant into the participant’s own 401(k) account, so technically this also is a transfer from one pocket to another, not a borrowing cost or loss.
Yes, it is deemed to be interest. Your observation however of transferring from one pocket to another is right on.
When you borrow from a 401(k) plan, you no longer earn investment returns on the amount you borrow from the account. In effect, that money is no longer in the 401(k) plan earning money; you’ve borrowed it, and it is out doing something else. So, although the interest you pay on the loan goes back into your 401(k) account, the true cost of the loan is the amount you would have earned on that money had you not borrowed it from the account. It is what we call opportunity cost: you’re missing out on the opportunity to earn money on those investments, if you hadn’t borrowed funds from them—and it is a tricky concept. Don’t fall for those pitches that “you’re paying yourself back.” That’s not all that’s happening—you’re also missing out on the investment earnings on those funds that were borrowed.
Very well said. You should not fall for those pitches that say, “you are paying yourself back.”
And I totally agree the opportunity cost can be huge.