401(k) Loans

Loans 101

What Is A 401(k) Loan?

Most 401(k) plans allow participants to borrow money from their accounts. The money you borrow will be deducted from your account and will no longer be invested for retirement. As you pay back the loan, the principal and interest are added back to your account and reinvested.

When you borrow from your 401(k) you sign a loan agreement which will spell out the terms including the length of the loan, interest rate, payments and any fees involved.

To see if your plan offers loans, check with your employer or review your Summary Plan Description, a document that explains in detail how your plan works. Special rules apply, and each plan may have its own rules, so be sure to review them carefully before borrowing from your plan.

Whose Money Are You Borrowing?

The funds come from your account, which you pay back, with interest. The interest is directly credited to your 401(k) account.

You repay the loan in equal installments with repayments automatically deducted from your paycheck. You are required to make payments at least once every quarter.

Most plans allow for “general purpose” loans, which are typically for any use (see more below), and primary residence home loans. General purpose loans have a maximum repayment term of five years, while home loans generally carry a longer term of 15 to 25 years.

Some plans don’t allow you to continue your 401(k) contributions while you are making loan payments. Be sure you understand your plan’s rules before you borrow.

Caution: Job loss can cause 401k loan repayment

How Much Can I Borrow?

Most plans have a minimum loan amount ($500 – $1,000). The maximum amount you can borrow is generally governed by federal law and is limited to (1) the greater of $10,000 or 50% of your vested account balance, or (2) $50,000, whichever is less.

Keep in mind that the amount you can borrow from your 401(k) plan is determined based on your vested balance. Your own contributions into the plan are always fully vested, but employer contributions may be subject to a vesting schedule. Your employer may require you to work a certain amount of time before you get to keep any employer contributions.

What Are the Restrictions?

Most plans let you borrow for any reason, but this can vary. Some employers restrict the reasons for taking a loan to:

  1. Paying for education expenses for yourself, spouse or a child
  2. Preventing eviction from your home
  3. Paying unreimbursed medical expenses, or
  4. Buying a first-time residence.

How Much Does It Cost?

Most plans charge a one-time loan origination fee. You will also pay interest. The interest rate on your loan is determined by your 401(k) plan, but is typically the prime rate + 1%. Check with your employer or review your plan’s loan policy to make sure you understand any fees that you may need to pay.

What Are the Pros and Cons?

Here are some things to think about when considering a 401(k) loan.

Pros

  • You have ready access to cash when you need it.
  • Typically, loan repayments are conveniently deducted from your paycheck.
  • No credit check or long application process is required.
  • Most 401(k) loans have lower interest rates than a credit card or a personal loan, and the interest you pay goes back into your account.

Cons

  • If you should lose your job or leave the company, you will most likely have to pay back your loan in full, usually within 60 to 90 days.
  • Any unpaid portion of your loan will be treated as a taxable distribution. Depending on your age, most borrowers incur an additional 10% penalty. The defaulted loan, taxes and penalties can significantly diminish your account.

What Happens If I Default?

If you fail to make the required payments on your 401(k) loan, the loan will be in default and the remaining balance is considered a “distribution.” A distribution triggers taxation and may also be subject to a 10% penalty, depending on your age.

Here’s an example:

Let’s say you have a $7,500 loan and default on it. 40% or more of the money could go to the government, assuming 25% in federal taxes and 5% in state taxes, plus the 10% early-withdrawal penalty. So you might net only $4,500 from that $7,500 loan.

What Does a Default Cost?

The costs go beyond the immediate lost retirement savings, taxes, and penalties discussed above. You also miss out on the lost earnings over time that your money would have generated. Making things worse, many defaulting borrowers cash out their entire remaining account balance to cover taxes and penalties. For the average borrower, with a loan of about $8,000 and over twenty years to go until retirement, this adds up to $300K in lost savings at retirement!

Average defaulting borrower loses out on $300K

A real world story:

Marcus, 46 years old, became disabled and defaulted

“The reason we were in this spot to begin with, we had depleted most of our savings fairly close to this time. New vehicle and credit cards, there wasn’t enough balance available to handle it.”

What Is 401(k) Loan Insurance?

The role of any type of insurance is to protect against the risk of loss. If you own a home or a car, typically, you insure it. In fact, for the average household, their 401(k) money is even more valuable than their home, as a percentage of household assets.

401(k) loan insurance protects your retirement plan account from loss, in this case, from the risk of defaulting on your plan loan. 401(k) loan insurance prevents the default by automatically repaying the loan, leaving your retirement savings intact. You get to keep your balance.

Your 401(k) may represent one of your largest financial assets. It makes sense to protect it from unforeseen circumstances like losing your job or becoming disabled.

Why Is 401(k) Loan Insurance Necessary?

When you borrow through a 401(k) loan, you have an obligation to pay the loan back. But what if an unexpected life event such as a layoff or disability happens? Layoffs are routine these days.

If you lose your job or become disabled, you may not be able to make your loan payments. You could end up defaulting on your loan, and worse, go on to cash out your account.

Either way, you could lose thousands of future retirement dollars to taxes and penalties.

The impact on your retirement savings can be devastating.

401(k) loan insurance prevents loan defaults by paying your outstanding loan balance in full. You keep your balance and your savings can continue to grow until you retire. That is smart financial protection.

Why Does Custodia Financial Offer 401(k) Loan Insurance?

401(k) loan defaults are affecting millions of Americans and adversely affecting retirement plan outcomes.

The statistics are staggering:

Nearly $6 billion in loans default annually. 86% of 401(k) loans default when people lose their jobs.

86% of 401k loans default upon job loss

Fortunately, Custodia Financial realized that this significant form of retirement plan leakage is entirely preventable.

By insuring a 401(k) loan through a simple loan insurance program such as Retirement Loan Eraser, the loan is automatically repaid in the event of involuntary job loss or disability. Borrowers “keep their balance” and continue to enjoy decades of compounding in their accounts.

401(k) loan insurance is an important part of an individual’s overall financial wellness strategy.

How Can I Get 401(k) Loan Insurance?

Ask your employer or retirement plan provider about Retirement Loan Eraser or contact us.