Over the past few months, we’ve received emails from our newsletter subscribers asking about 401k loans.  I suppose it goes hand-in-hand with our current economy, as we look at real unemployment rates and other economic data.  Plenty has been written on the topic of 401k loans, but a real actionable checklist might be useful (including a few caveats).

401k Loan Considerations

A 401k loan may work well if you’re both desperate and have problems getting credit from other sources at reasonable rates.  If this is your situation, a loan is most likely a temporary fix for a larger problem, but certainly worth exploring. In other cases, such as financing a new side business, or furthering your education, a 401k loan seems like a more reasonable option. I would first encourage you to look for other “cheaper” sources of capital, but if they are unavailable, consider the following:

1. Once you take the loan, your money will no longer be growing for you both compounded and tax-deferred.
2. If you leave your job for any reason, most employers will require you to repay your loan balance within 60 days.
3. If you default on your loan for any reason, prior to the age 59 1/2, you’ll be taxed on the full amount at your earned income tax rate.  In addition, you’ll pay a 10% penalty from the IRS.

Best Practice- Taking the Loan

After determining that taking the loan is the most viable option for you, the following are logical steps to take along the way:

1. Get the Details: Contact your human resources/benefits department or consult your summary plan description to find out exact requirements to secure a loan from your 401k.
2. Calculate Your Needs Vs. How Much You Can Borrow: This should also be located in the plan documents.  However, if you’re making a call to your HR department- this is a must ask question.  Most plans have both minimum and maximum loan amounts.  ERISA makes allowance for a full, but most plans allow no more than 50% loan to current balance.
3. Determine the Repayment Period: Most plans will spread the repayment requirement over five years.  If allowable, paying your loan back sooner is a better option.
4. Determine Available Repayment Methods: Most plans require you to repay your loan through payroll deduction (the same as the original contribution).  However, unlike the original contribution, you’ll be making your loan payments on an after-tax basis.  Remember you’ll be paying tax again on these same dollars at the time of final distribution as well.
5. Calculate the Cost of Borrowing: Your employer will determine an appropriate interest rate on the loan within the parameters set by the IRS.  Normally, this will be Prime Rate + 1%.  You’re really paying yourself interest as the money normally gets re-deposited to your own account.  In spite of this, it most likely will not compensate for the double taxation mentioned earlier.  Once you find out the loan rate, bankrate.com has a great calculator tool for planning- give it a look.

TIAA-CREF reports that almost 44% of those who borrow against their 401k, later regret the decision.  With this in mind, be sure to count the cost.  Hopefully, the steps described above will help you to make an informed decision.

Have you borrowed from your 401k before? Please tell us about your experience? Did anything unexpected occur?