Is there anything your 401(k) plan can’t do? It allows for tax-deferred earnings in traditional accounts and tax-free earnings in Roth-style accounts. And traditional plans enable you to make contributions in pretax dollars, helping to reduce your taxable income. It even offers a menu of professionally managed investments from which to choose.
But there may be another feature of your 401(k) (or a similar retirement plan) that you haven’t considered: You may actually be able to borrow money from your account. In 2012, the Employee Benefit Research Institute revealed that 59 percent of 401(k) plans that were surveyed offered loans to participants.
Read the rules
The IRS currently allows you to borrow up to 50 percent of the total vested assets in your account, up to a maximum of $50,000. There may be loan minimums and certain other restrictions, depending on your plan’s specific loan availability calculations. For 2020, this has been updated to allow even more access without penalty if you qualify.
If you are affected by COVID-19, you may withdraw up to $100,000 from any type of retirement account and the 10 percent penalty that applies to those under 59½ is waived for distributions made in 2020.
Another plus — no mandatory withholding and distributions may be taxed as income over three years: 2020, 2021 and 2022 vs. one. If you can pay back the loan within three years, you can claim a refund on the loan taxes paid. 401(k) participants can now take out 100 percent of their vested balance (previous rules limited borrowers to 50 percent with a cap up to $50,000 — it is now up to $100,000 — as a loan and payments can be delayed for up to one year).
The CARES Act waives RMDs from retirement accounts for 2020. Not yet subject to RMDs (70½ or younger)? Then you can now wait until age 72 to begin.
How a 401(k) loan works: The 401(k) sponsor (your employer) sells a portion of the plan investments proportionally from your account equal to your loan amount.
Check the rules before you borrow
- You can generally borrow up to half the vested amount in your account, but no more than $50,000. (See 2020 exception above)
- The loan must generally be paid back within five years. If the loan is used to purchase a house, you may have more time to repay the balance.
- Payments are usually made via payroll deduction.
- If you leave the company before repaying the loan, the balance could be treated as a distribution on which you’ll be required to pay taxes and possibly a 10 percent early withdrawal penalty on all pretax contributions and earnings withdrawn.
Weigh the pros…
For some, the primary attraction of a 401(k) loan is the simplicity, low cost and privacy not generally associated with a bank loan. And unlike banks and other sources of loans, 401(k) loans are not reported to credit agencies.
Another benefit is the low interest rates, which are generally tied to the prime rate and repaid to your account.
If you separate from the company before you fully repay your loan, you will be required to pay the balance within 30 days or owe federal income taxes. You may also owe a 10 percent early withdrawal penalty by the IRS.
Second, be aware of the potential “opportunity cost” of borrowing from a 401(k) plan — the loss of any potential return you’ll miss out on if the portfolio returns are positive. Many plans will not allow you to continue contributing until your loan is repaid.
Missed earnings can add up and result in a lower balance in retirement savings. Returns in stock and bond markets are not constant — the average return is often earned in a few market surges occurring over a few days or weeks. If your plan money is out of the market when those surges occur, your opportunity cost could be much higher than you expected.
Make the most of your retirement plan
The primary reason to invest in an employer-sponsored qualified retirement plan is to pursue your long-term financial goals. Remember, the earlier you invest and the longer you stay invested, the more you’ll potentially benefit from tax-deferred or tax-free compounding.
Source/Disclaimer: This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.