One of my first positions was in a 401(k) call center, where one of the most common questions people asked was about taking a plan loan to pay off their credit card debt.
When I went to my manager for guidance, I was told in no uncertain terms that we were never ever to broach this topic, as it bordered on financial advice. Throughout my career I have seen that employers refuse to discuss 401(k) plan loans as a source of debt financing. To the extent plan materials provide any advice regarding loans, the message is usually centered on the dangers of borrowing from your retirement nest egg.
The reluctance to communicate the prudent use of 401(k) plan loans can be seen in the number of people holding different types of debt.
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While numbers vary, 22% of 401(k) plan participants have a 401(k) loan outstanding, according to T. Rowe Price’s Reference Point 2020. Compare this to 45% of families holding credit card debt and 37% having vehicle loans (source: U.S. Federal Reserve Board Summary of Consumer Finances). Yet the interest rate charged on 401(k) plan loans is typically far lower than other available options. The annual interest rate of plan loans is typically set at Prime Rate +1%. As of March 2021, prime +1 is 4.25%. The average annual percentage rate (APR) on credit cards as of March 2021 is 16.5%. And depending on your state, payday or car title loans have an APR varying from 36% to over 600%!
The basics of how it works
Participants in an employer-sponsored defined contribution program, such as a 401(k), 457(b) or 403(b) plan, can typically borrow up to 50% of their plan account balance, up to $50,000.
Loans other than for purchase of a personal residence must be repaid within five years. Repayments are credited to your own account as a way to replenish the amount borrowed, and there are no tax consequences so long as the loan is repaid.
What’s at stake
I still think about my call center experience and wonder why we couldn’t have been more helpful. I would never recommend tapping your retirement savings to pay for current expenditures, but the need for short-term borrowing is an unfortunate reality for many people.
If you have to borrow, why not at least examine the advantages of tapping your plan over other short-term financing options? Besides lower interest rates here are some potential advantages of 401(k) loans:
- A 401(K) loan is not reported to credit bureaus such as Equifax, TransUnion and Experian, and therefore not considered in the calculation of your credit score.
- Your credit score will not suffer in the event that you “default” on a 401(k) loan by not repaying any outstanding balance if you leave your job.
- In the event that you miss a payment (for example, by going out on an unpaid leave of absence), you are not charged any late fees. (However, the loan may be reamortized so repayments are completed within the original term.)
- The interest rate on your plan loan is fixed through the term of the loan and can’t be raised.
Of course, there are disadvantages as well, including:
- Beyond the interest payments, there is the cost of the investment gains you’re giving up on the outstanding loan balance, ultimately reducing your retirement assets.
- Most plans charge fees of $25 to $75 to initiate a loan, as well as annual charges of $25 to $50 if the loan extends beyond one year. If you are borrowing small amounts, this may eliminate most if not all of the cost advantage over credit debt.
- Since you make repayments using after-tax dollars, you are being double-taxed when you eventually receive a distribution from the Plan.
- Unlike other consumer debt, you can’t discharge the debt in the event of bankruptcy.
- If you leave your job during the repayment period, you may be required to make a balloon payment to repay the loan in full — either to the original plan or a Rollover IRA. Otherwise, the outstanding balance is then reported as taxable income, and you can also be assessed an additional 10% early withdrawal fee on the outstanding balance. (Although some plans do permit terminated participants to continue repaying their loans from their personal assets rather than through payroll deduction, but this is not the norm.)
Good news
Final regulations have been issued by the IRS on a provision (Section 13613) of the Tax Cuts and Jobs Act of 2017 (TCJA) extending the time that terminated employees can roll over their outstanding 401(k) loan balance without penalty. Previously, you had 60 days to roll over a plan loan offset amount to another eligible retirement plan (usually an IRA). The new rules stipulate that effective with loan offset amounts occurring on or after Aug. 20, 2020, you have until the due date (with extensions) for filing your federal income tax return, to roll over your plan loan balances.
By way of example, if you leave your job in 2021 with an outstanding 401(k) plan loan, you have until April 2022 (without extensions) to roll over the loan balance.
Make the right choice – but tread carefully
After all other cash flow options have been exhausted — including such possibilities as reducing voluntary (unmatched) 401(k) contributions or reviewing the necessity of any subscription services which are automatically charged to your credit card - ,) — participants should compare plan loans to other short-term financing options. Some of the points to specifically consider include:
- Do you expect to remain in your job during the loan repayment? As noted above, if you leave your job you may be required to make a balloon payment of the outstanding balance or face taxes and penalties on the outstanding balance.
- If you are uncertain about remaining in your job, do you have the ability to pay off the outstanding balance if required? The research behind plan loans shows there is real damage to your long-term retirement income adequacy from defaults, considering the accompanying taxes and penalties.
- If you take a plan loan, can you still afford to contribute to your retirement plan? In particular, you should strive to contribute enough to receive the maximum matching contribution provided by your employer.
- If you are still considering a loan after answering these gating questions, you should compare the total cost of different debt options. Vanguard has a tool available on its website that lets you compare plan loans to other debt options and includes the forgone investment experience during the term of the loan. (You should also include any loan fees in the cost comparison.)
Again, no one advocates this type of borrowing except if it’s more advantageous than your other alternatives. So, if your employer isn’t walking you through the pros and cons of a taking a loan against your 401(k), investigate them for yourself.
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