A CLOSER LOOK AT 401(k) PLAN LOANS (and their consequences)
by Megan Riley, J.D., LL.M
High unemployment, rising credit card debt, restrictive lending and a sluggish economy have many people looking for a quick cash option. A research study authored by Brigitte C. Madrian, John Beshears, James J. Choi and David Laibson, “The Availability and Utilization of Plan Loans,” (HKS Faculty Research Working Paper Series RWP11-023, June 2011) reveals that loan provisions are included in 90 percent of 401(k) plans.
Additionally, more than 1 in 5 participants have taken loans from their plans at one time or another and, over a 7-year period from 2002 to 2008, almost half of all participants borrowed from their plans. Based on this surprisingly high use of 401(k) plan loans, an obvious question arises: Is this really a good idea? As with all financial decisions, individual needs and circumstances must be considered. But certainly there are important considerations anyone should understand before taking a loan from a 401(k) plan.
• The loan interest is not tax deductible.
401(k) loans are considered consumer loans, and therefore offer borrowers no tax advantages. Plan participants should explore other loan options, such as home equity loans, before taking a 401(k) loan.
• There are loan fees associated with taking a 401(k) loan.
Typically, there are origination fees and annual maintenance fees on 401(k) loans, and it is the participant taking the loan, not the Plan or employer, who will pay these loan fees, which are deducted from the borrower’s account.
• All loan payments are all made with after-tax dollars.
Let’s say the participant is in the 28 percent tax bracket and the monthly interest payment is $300. He/she must be paid $416 in gross earnings in order to make the $300 payment. When he/she retires and begins taking withdrawals, he/she will have to again pay income taxes on those dollars.
• Loan repayments are made through payroll deduction.
This repayment structure is certainly convenient. However, if a participant terminates employment and fails to repay an outstanding loan, the money which is owed is considered a distribution, meaning the borrower will owe federal and state income taxes on the outstanding balance. In addition, the borrower may possibly owe an additional 10 percent penalty if he/she is under age 59½. He/she will receive a Form 1099 for the amount outstanding.
• Participants are losing earning potential.
The net effect of borrowing from a 401(k) plans is that there will be less money invested in the Plan. The money borrowed money from the retirement plan no longer participates in earnings (or losses) from interest, dividends and/or capital gains.
• A 401(k) loan may increase participant taxes.
If participants have to reduce pre-tax 401(k) contributions by the amount of the loan payment, they will increase their taxes by increasing their taxable income. Additionally, because payments to the loan are debited post-tax, they cannot be claimed as a deduction on tax returns.
• A 401(k) loan affects participant psychology regarding retirement saving. Retirement money, unless there are mitigating circumstances, should be left intact for retirement. It is easy to get in the habit of dipping into 401(k)s instead of creating the discipline to save for things needed along the way, a habit that could negatively affect how much remains for retirement needs. Keep your 401(k) in a loan-free zone.