What you need to know about 401(k) loans

The 401(k) has grown in popularity, as many corporations are stepping away from defined benefit programs, becoming one of the most popular retirement plan options available.

What’s a 401(k) Again?

401(k) plans are employer sponsored plans that allow eligible employees to make tax-deferred contributions towards retirement savings (in many cases Roth, or post-tax, contributions are now allowed as well).  As the participant, you get to decide how to invest your retirement assets across the available fund choices.

Gimme Some Money Please!

For some, an attractive feature of 401(k) plans is the loan provision.  We all know that life loves to surprise us and, where appropriate, taking a loan from your 401(k) can help mitigate unexpected circumstances.

However, it’s important to remember that this is a loan—not free money.  If you take a loan from your 401(k) you are promising to pay it back, just like any other money you borrow from a friend or a bank.  A repayment plan will be established and you will be expected to repay the money according to the agreed upon terms.

There’s no escaping interest when you are repaying the loan. Usually the rates are very low, hovering around 1%. And the good news is you’re paying that interest back into your account, so there will be a bit more going back into your retirement account than what you took out.

Watch Those Fees

Most plans will charge a loan processing fee.  These can range anywhere from $50 and up.  Depending on who is involved with your plan, you could get hit with more than one charge.  For example, the bookkeeper may have an administrative charge and the custodian may hit you with a processing fee.  These charges will be different for each plan, so make sure you know how much it’s costing you to set up the loan.

What Happens When I Retire or Get Another Job?

Typically people will either leave there 401(k) where it’s at, or they will roll it over into another employer sponsored plan or IRA account.

If you leave it where it’s at, you may have the option to continue making payments on the loan.  There’s also a good chance of being asked to repay the loan in full.  If you fail to keep up with payments or can’t repay the outstanding balance then you will default on the loan.  If you decide to transfer your 401(k) to another retirement account you can either pay off the outstanding balance or default.

Be mindful of defaulting on a 401(k) loan as the defaulted loan amount will be treated as a taxable withdrawal. If you are not 59 ½ or older, the IRS will consider this an early withdrawal and it will be subject to a 10% penalty in addition to income taxes.  This has the potential to put a sizable dent in your retirement account.

What Should I Do?

A foundational step in financial planning is to establish an emergency fund.  This should represent 3-6 months of your household expenses.  Having some easy to reach savings will help you stay nimble and potentially keep you from needing to access your retirement savings prematurely.  Taking a loan from your 401(k) may be helpful, but try not to let it be your first choice.

At Sigdestad Financial we specialize in retirement planning. Is your 401(k) on track with your retirement goals? Please contact us if you would like to have a complimentary review of your 401(k) plan with one of our financial advisors.