401(k) Loans: Yes or No?

Are you contemplating taking a loan from your 401(k) plan? If so, here are key factors to consider before reducing your overall retirement savings:

1. The loan amount reduces the overall 401(k) account balance where earnings can grow tax-deferred.

2. The interest rate, while fairly low compared to other commercially available loan options, is usually less than a reasonable rate of investment return.

3. The loan principal and interest are repaid with after-tax money, but you will still pay taxes on those funds upon distribution in retirement.

All of these items together are a recipe for hindering the advantages of tax-deferred savings inside a 401(k) plan. With that said, your circumstances could leave you no other option and we encourage you to take full advantage of your company’s education program discussing their plan features. We believe it’s vital to educate yourself when considering taking a loan from your retirement account by answering the following questions:

1. Does my company offer education programs discussing loans from my plan?

2. What is the minimum loan amount?

3. Do they offer flexible repayment options?

After careful deliberation, if you have decided to take a 401(k) loan, you need to be aware of how your company’s loans would be repaid.

Loan repayment schedules are set up to include substantially equal periodic payments which include both principle and interest and must be repaid within 5 years. However, if the loan is for the purchase of a primary residence, the plan may permit a lengthier repayment time period, such as 5 to 30 years.

Distribution of loan proceeds are not considered a distribution of plan assets and thus are not subject to taxation, unless you default on the loan. Plans have options for how they wish to treat defaulted loans. One common option is a “deemed distribution”. Upon a defaulted loan, the outstanding loan amount becomes a taxable distribution of plan assets, plus 10% tax-penalty if you are under the age of 59½.

Another option for handling a defaulted loan is a plan “offset”, where your account balance is reduced or offset by the unpaid portion of the loan. This offset amount is treated as a distribution of plan assets which is eligible for rollover. Until recently you would have up to 60 days to rollover the outstanding loan amount in full into an IRA or another eligible tax-qualified employer plan to avoid a taxable distribution. Effective January 1, 2018, the TCJA extended the usual 60-day time-period until the federal tax filing deadline, including extensions, if the plan offset is due to the termination of service or an entire plan termination. Note: the 60-day rollover period still applies to actively employed individuals who default on a loan while still working for the employer.