Borrowing from a 401(k) plan can prove to be a taboo subject that some clients are reluctant to consider even if the circumstances require that a loan otherwise be obtained from an outside source.  A client’s hesitation to raid his or her 401(k) nest egg in order to fund other life events is understandable—these hard-earned funds are supposed to be earmarked to provide income during a long and well-deserved retirement. 

Despite this, there are many scenarios where a client will be obligated to borrow funds in order to finance major purchases or unanticipated emergency expenses. While a 401(k) plan loan will not always be the best option, in some cases such a loan can actually help a client come out ahead—if the circumstances are correct.

Why Consider a 401(k) Loan?

A 401(k) plan is not required to provide for plan loans—and even if the plan does, the value of the loan cannot exceed

  1. the greater of $10,000 or 50% of the account balance or
  2. $50,000, whichever is less. 

While 401(k) loans generally have a bad reputation, for a financially responsible client who has a short-term need for additional funds (note that 401(k) loans generally must be repaid within five years), a 401(k) loan can provide an appealing option.

Many individuals who take out 401(k) loans do so in order to finance a real estate investment. For example, it may be beneficial for a client to borrow against his or her 401(k) in a situation where he or she is buying and selling a home at the same time. The 401(k) loan can be used as a bridge to pay expenses related to the new home until the proceeds from the sale of the old home are received—eliminating the necessity of obtaining additional bank financing.

Other clients may consider 401(k) loans as short-term college tuition financing options—rather than making payments ratably throughout the school year, the loan can cover the costs of tuition up front (often at a discounted rate). This can be an attractive option if the client is able to repay the loan throughout the same school year (repayments are generally made via payroll deduction).

For many clients who have unforeseen expenses, or wish to finance a large purchase, a 401(k) loan may be attractive because no credit check is required (as would be with a traditional bank loan) and interest rates may be more favorable than other options. Further, the loan will not impact a client’s credit rating and can usually be obtained fairly quickly. However, the client should carefully consider the objections discussed below before using the 401(k) loan option.

Objections to a 401(k) Loan

Importantly, the client should consider his or her ability to repay the loan balance within a short time frame while continuing to make contributions to the 401(k). Generally, the loan balance must be repaid within five years and payments must be made at least quarterly (special rules apply in the case of a 401(k) loan taken out to finance the client’s principal residence).

For many clients, repaying the loan balance within five years can inhibit the ability to make further contributions to the plan—thus reducing the eventual overall account value at retirement.

One of the major objections to using a 401(k) loan to finance non-retirement expenses is the opportunity cost of the loan. Because the funds are withdrawn from the client’s 401(k), the available balance is reduced—as is the corresponding growth factor. In a market upturn, the client who has borrowed against his or her 401(k) can miss out on investment growth that would have otherwise increased the overall value of the 401(k).

Further, if a client misses a payment and cannot pay for 90 days or more, the money is taxed as a distribution and can be subject to the additional 10% penalty tax if the client is under age 59 ½. If the client leaves his job (or is fired), the loan must be repaid within 60 days in order to avoid taxes and penalties.

Conclusion

While a 401(k) plan loan will not provide a solution to every client’s cash flow problems, for the financially conscientious client, it may provide a viable option in order to avoid incurring additional outside debt—if repayment can be accomplished quickly and responsibly.

Originally published on Tax Facts Onlinethe premier resource providing practical, actionable and affordable coverage of the taxation of insurance, employee benefits, small business and individuals.    

To find out more, visit http://www.TaxFactsOnline.com. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed without prior written permission.