401k Loans

Second only to the average home, the 401k retirement account is often the largest asset American families have in their possession. After falling on hard times, 401k loans look attractive in that investors can “borrow from themselves” in order to meet their immediate cash needs. Unfortunately, there are several criteria for qualifying for a 401k, which we’ll get to below:

The How to: 401k loans
In the truest definition of the word, 401k loans aren’t actually loans. In actuality, they’re a commonly-used process through which investors can access their account balances today with the understanding that they will deposit what they borrowed (plus interest) back into their account. So, where borrowing from a lender may require you to pay back principle plus interest, and the interest is lost, borrowing from a 401k means that you pay yourself interest payments. In terms of raw dollars and cents, nothing is lost; instead, balances are merely shifted.

In most cases, the resulting interest is negligible in terms of the cost of borrowing from other sources. A loan from a bank, for example, will cost interest and fees, which are not returned to your 401k account. A loan from a credit card at a high rate of interest of 20% per year, for example, is often a worse choice than borrowing from your 401k, since it is unlikely that your 401k will beat the interest loss on credit card debt.

Thinking about moving jobs?
One time that investors shouldn’t tap their 401k savings for immediate cash is when they think they might be moving jobs in the future. Upon moving to a new employer, the loan taken against a 401k is immediately recalled. That is to say that within 60 days, all the money borrowed, plus accumulated interest, must be paid back into the account.

If the funds are not returned, then the investor will incur a penalty of 10% of the current outstanding loan balance. This 10% penalty is not restricted to unpaid loans; in fact, it is assessed on all early withdrawals from a 401k. As the money has not been paid back in within 60 days, the IRS considers any amount withdrawn to be an early distribution of earnings.

This rule is also true for borrowers who will soon be taking retirement distributions. If it was your plan to retire at 59, and you’re only a few years from retirement, then it may be best to think twice about taking a loan. Once distributions are made from your retirement account, then any loan amount not yet repaid will be considered an early distribution and thus incur the same early withdrawal penalty of 10%. In this case, borrowing from other sources may be a better option, since the rate of interest differential is unlikely to exceed the cost of the penalty plus gains on your 401k account.

Is Bankruptcy Inevitable?
Bankruptcy experts usually advise savers not to touch their 401k if they think the cash will not make a difference in their current financial position. As you may or may not be aware, both 401ks and IRAs are bankruptcy protected up to $1 million in many states, and thus are exempt from any bankruptcy proceedings.

However, if you were to take a $100,000 loan from your 401k to solve your current financial struggles before entering bankruptcy, then that $100,000 loan will be considered “fair game,” and divided amongst your creditors. If you were to instead leave the money in your 401k, then it would be protected in its entirety up to $1 million.

Check first!
Always speak to your financial planner, human resources department, or plan sponsor to ensure that there are no fees for a loan that exceed your own mandated rate of interest that you must pay yourself. Some fund sponsors have rules that prohibit employer matching until the full principle of the loan is repaid. Others have no such clause and will continue to match new contributions with employee matching dollars as long as the investments pour in regularly.

Either your company or your plan sponsor should be able to speak in clear terms about the laws that govern your particular state. As with most financial-products, regulation exists at the state level that varies from one state to the next, and it would be to your advantage to speak to a capable financial planner before accepting any loans against your current retirement fund balances.

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