Sometimes life happens, and it’s nice to have an option for a short-term cash infusion without a lot of risk or penalty. Enter the 401(k) loan. A 401(k) loan allows employees to borrow from their retirement savings plan and pay it back to their plan over time with interest.
To get started, employers need to set up a 401(k) loan policy with their plan managers, who will oversee and administer the benefit. 401(k) loan rules are not the same for every plan, so be sure to discuss the details with your plan manager and communicate all the small print to employees. We’ll walk you through some of the basics of how the loan may work for your employees and discuss some questions you should pose to your employees below.
Please note: IRAs and IRA-based plans (SEP, SIMPLE IRA and SARSEP plans) cannot offer loans.
How much can an employee borrow?
Legally, an employee can borrow up to 50 percent of their plan’s vested balance up to a maximum of $50,000 within a 12-month period. An exception to this limit is if 50 percent of the vested balance is less than $10,000, in which case the employee may be able to borrow up to $10,000—but the IRS does not require all plans to include this exception.
Also, if you, the employer, offer your employees company-matching contributions, there could be limitations depending on your company’s vesting rules.
Under the CARES Act, the IRS increased the dollar limit on 401(k) loans made between March 27 and September 22, 2020 from $50,000 to $100,000 for individuals whose health or finances were impacted because of COVID-19. Please note:Some qualified plans require your spouse’s written consent if the loan amount is over $5,000.
Can the employee take out more than one loan at a time?
401(k) loan rules are not the same for every plan. Some companies allow multiple 401(k) loans while others do not. Generally, an employee cannot take out a new loan if they are no longer working for your company (the company in which the 401(k) plan resides) unless the plan specifically allows for it. These things (among other details) are completely contingent upon your company’s 401(k) plan rules.
How does the employee make payments on the loan?
401(k) loan repayments are typically made through a payroll deduction—with the longest repayment term allowed being five years. This five-year repayment term may be waived if the employee is using the loan to purchase a primary residence. Payments must be made at least quarterly. However, if the employee is in the armed forces, you, the employer, may suspend loan repayments during the employee’s period of active duty and extend the repayment period by this timeframe. Also, the CARES Act allowed plans to suspend loan repayments that were due from March 27 through December 31, 2020. Interest on these payments is usually calculated at prime rate +1%, but the 401(k) plan you offer your employees may have different rules, so be sure to check the small print before advising your employees.
What if the employee defaults on the loan?
Make sure your employee knows that if they default on the loan for any reason, then it’s then treated just like a 401(k) withdrawal—meaning that it’s subject to taxes and possibly the 10 percent penalty for early withdrawal. The employee may be able to avoid the income tax consequences by rolling over all or part of the loan’s outstanding balance to an IRA or eligible retirement plan by the due date (including extensions) of your federal tax return in the year the loan would be treated as a distribution.
What’s the difference between a 401(k) loan and a 401(k) withdrawal?
401(k) loans are not the same as 401(k) withdrawals. First off, 401(k) withdrawals aren’t required to be paid back, unlike 401(k) loans. Additionally, withdrawals are considered taxable income and may be subject to a 10% penalty for early withdrawal if the person who makes the withdrawal is under age 59 ½.
401(k) loans are not dependent upon hardship. However, there are some 401(k) plans that offer hardship withdrawals. These withdrawals are need-based and usually avoid the 10 percent early withdrawal penalty.
401(k) loans are typically an option as long as the borrower is currently working for the company that sponsors your plan. If the borrower leaves the job for any reason, they may have to pay any outstanding loan in full in a very short time frame (unlike 401(k) withdrawals, which are one and done).
Weighing the pros and cons of a 401(k) loan
It’s important that your employees consider the good the bad and the ugly before taking out a loan on their 401(k) plans.
- These are short-term loans up to 50 percent of the plan balance or $50,000
- Payments are usually taken out of the employee’s paycheck, and interest is payable to back into the employee’s plan; essentially, the employee pays interest to hiself or herself.
- No tax penalties
- Loan amounts lose out on market growth
- If the employee leaves your company, the loan balance must be paid back almost immediately or within a very short time frame
- If the loan is considered in default, it converts to a 401(k) withdrawal and is subject to tax and 10 percent penalty for early withdrawal if the borrower is under age 59 ½
The amount the employee can borrow may depend on your company’s plan, but there aren’t any limits in place for what the borrower can do with the money. However, there are a few things your employee should consider before pulling the money out of their retirement account.
Questions to have your employees consider before taking out a 401(k) loan
Make sure your employee considers their options carefully; it may help to ask them the following questions:
Have you explored all your funding options?
Before an employee decides to pull money out of their retirement account, make sure they have explored all of your options. Do they have a savings account or an emergency fund they can use instead? Although a 401(k) loan is a low-risk short-term cash option, it shouldn’t be the first option because it can interfere with the employee’s long-term investment strategies.
What are you using the funds for?
While your employee may not wish to share this information with you (and you should not put them on the spot), you should ensure the employee carefully considers the reason for the loan. Is the employee using the proceeds of the loan for home repairs or improvements, education costs, or to pay off debts? The employee may wish to consult a financial advisor to assist in comparing the interest rates on alternative funding sources and/or the potential loss on market gains before the employee pulls the funds out of their 401(k) account. The employee may wish to consider other options that have deferred or special interest-only payments. Because 401(k) assets are typically protected from creditors and bankruptcy proceedings, using this money to repay debt is not always the recommended choice.
How much should you borrow?
The employee should avoid pulling more than is needed from the retirement account because the employee won’t want to miss out on potential market growth. It could be a good idea to reduce any high-interest debt with this loan, but taking out more than is needed may leave a gap in the employee’s future plan for retirement.
Should you continue saving for retirement?
The employee may be tempted to suspend their contributions in the 401(k) plan while paying off the loan, but if the plan allows it, the employee should continue making contributions in order to maintain their long-term retirement strategy.
Alternative funding sources
Since borrowing from a retirement plan shouldn’t be your employee’s first line of defense, here are some alternative funding sources your employee should consider:
- A health savings account (or HSA) if the money is needed for qualified medical expenses
- Emergency savings or other non-retirement savings, such as checking, savings, and brokerage accounts
- Withdrawals from a Roth IRA (withdrawals are usually tax- and penalty-free if you withdraw up to your contributed amounts)
- Transfer high-interest credit card balances to a new lower (or zero) interest credit card instead of borrowing to pay the balance off
- Home equity line of credit or a personal loan
So, if your employees are looking to take out 401(k) loans, confirm your plan offers them by checking in with your plan sponsor or referring to your summary plan documentation. Then, make sure your employees cross-check the small print with other funding options.