One of my first jobs was in a 401 (k) call center, where one of the most common questions people had was whether to take out an off-plan loan to pay off their credit card debt.
When I went to ask my manager for advice, I was told bluntly that we should never broach this subject, as it confined to financial advice. Throughout my career, I have seen employers refuse to discuss 401 (k) plan loans as a source of debt financing. Since the plan documents provide advice on lending, the message usually centers on the dangers of borrowing from your retirement nest egg.
The reluctance to communicate the prudent use of 401 (k) scheme loans can be seen in the number of people holding different types of debt.
Although the numbers vary, 22% of 401 (k) plan members have an outstanding 401 (k) loan, according to T. Rowe Price 2020 reference point. Compare that to 45% of families with credit card debt and 37% with a car loan (source: US Federal Reserve Board Summary of consumer finances). Still, the interest rate charged on 401 (k) plan loans is usually much lower than that of other available options. The annual interest rate for loans under the scheme is generally set at the prime rate + 1%. As of March 2021, prime +1 is 4.25%. The average annual rate (APR) on credit card in March 2021 is 16.5%. And depending on your condition, payday or car title loan have an APR varying from 36% to more than 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 to $ 50,000.
Loans other than for the purchase of a personal residence must be repaid within five years. Repayments are credited to your own account to replenish the amount borrowed, and there are no tax consequences as 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 using your retirement savings to pay for everyday expenses, but the need to borrow for the short term is a sad reality for many people.
If you need to borrow, why not at least consider the benefits of using your plan over other short-term financing options? Besides lower interest rates, here are some potential benefits of 401 (k) loans:
- A 401 (K) loan is not reported to credit bureaus such as Equifax, TransUnion, and Experian, and therefore is not counted in calculating your credit score.
- Your credit score won’t suffer if you “default” on a 401 (k) loan by not paying off any outstanding balances if you quit your job.
- In the event that you miss a payment (for example, going on unpaid leave), you will not be charged any late fees. (However, the loan can be amortized so that repayments are made within the original timeframe.)
- The interest rate on your personal loan is fixed for the duration of the loan and cannot be increased.
Of course, there are also downsides, including:
- Beyond the interest payments, there is the cost of investment gains that you forfeit on the outstanding loan balance, ultimately reducing your retirement assets.
- Most plans charge a fee of $ 25 to $ 75 to initiate a loan, as well as an annual fee of $ 25 to $ 50 if the loan spans more than a year. If you borrow small amounts, it can eliminate most, if not all, of the cost advantage over credit debt.
- Because you are making after-tax dollar refunds, you are taxed twice when you eventually receive a distribution from the Plan.
- Unlike other consumer debt, you cannot pay off debt in bankruptcy.
- If you quit your job during the repayment period, you may need to make a lump sum payment to repay the entire loan, either to the original plan or to a rolling IRA. Otherwise, the unpaid balance is then reported as taxable income, and you may also be charged an additional early withdrawal fee of 10% on the unpaid balance. (Although some plans allow terminated members to continue to repay their loans from their personal assets rather than through payroll deductions, but this is not the norm.)
The final regulations were issued by the IRS on a disposition (Section 13613) of the Tax Cuts and Jobs Act of 2017 (TCJA) extending the period during which terminated employees can roll over their 401 (k) loan balance without penalty. Previously, you had 60 days to transfer a plan loan compensation amount to another qualifying retirement plan (usually an IRA). The new rules state that from August 20, 2020, as of August 20, 2020, you have until the due date (with extensions) to file your federal income tax return, to carry over your loan balances. diet.
As an example, if you quit your job in 2021 with a current 401 (k) plan loan, you have until April 2022 (without extension) to roll over the loan balance.
Make the right choice, but be careful
Once all other cash flow options have been exhausted – including possibilities such as reducing voluntary (unmatched) 401 (k) contributions or reviewing the need for any subscription services that are automatically charged to your credit card -,) – participants should compare plan loans to other short-term funding options. Some of the points to specifically consider include:
- Do you plan to keep your job while the loan is repaid? As noted above, if you quit your job, you may need to make a lump sum payment of the unpaid balance or pay taxes and penalties on the unpaid balance.
- If you are not sure if you will keep your job, do you have the option of repaying the outstanding balance if necessary? Plan loan research shows that defaults do real damage to your retirement income adequacy in the long run, given the taxes and penalties that go with them.
- If you take out 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 blocking questions, you should compare the total cost of different borrowing options. Avant-garde has a tool available on their website which allows you to compare plan loans to other borrowing options and understands the investment experience lost during the life of the loan. (You should also include any loan charges in the cost comparison.)
Again, no one is advocating this type of loan except if it is more advantageous than your other alternatives. So if your employer doesn’t explain the pros and cons of a loan against your 401 (k), investigate them for yourself.
Alan Vorchheimer is a Certified Employee Benefits Specialist (CEBS) and Director of Wealth Management Practice at male, an integrated HR and benefits consulting, technology and administration company. Alan works with large corporations, the public sector and multi-employer clients to support the management of defined contribution and defined benefit plans.