How To Plan For Borrowing From Your 401(k) Plan

Borrowing from your 401 (k) Plan can be quite a temptation. However, before you actually take your money out, you must be aware of all the consequences. On one hand, a 401(k) loan can be easier to get at a reasonable interest rate for dire needs. On the other hand, it can cost you tax benefits and upset your retirement plan. An informed decision is always a wise decision.
How to Plan for Borrowing from your 401(k) Plan
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Borrowing from 401(k) Plan

Borrowing from your 401(k) plan is a decision you should make only after being fully aware of all the pros and cons of that decision. The actual borrowing from 401(k) plan is not very complicated. The complexities lie instead in deciding whether doing so is going to be beneficial for you, and knowing the precautions that you must take to avoid additional tax burden. So before you take a decision, be aware of what it has in store for you.

Know the terms & conditions of borrowing from 401(k) Plan

The 401(k) plan is a retirement plan that allows

you to plan for your post-retirement life apart from providing you certain tax benefits, and depending upon the terms of your plan, also a matching contribution from your employer. Thus, when you borrow from this plan, you must make sure to understand the terms and conditions that would be applicable to you.

As the first step, carefully go through the plan document, and make sure you have the answers to the following questions:

  • Question (i) Whether your 401(k) plan allows you to borrow ?

Most but not all 401(k) allow the provision of borrowing. So first confirm the availability of such option.

  • Question (ii) What is the maximum amount you can borrow ?

As a rule you can borrow 50% of your vested balance in the 401(k) plan with a maximum limit of $50,000. An exception is when 50% of your balance is less than $10,000, in which case you can still borrow up to $10,000, provided you have that in your account. Generally there are no other restrictions, but make sure of that by going through the plan document.

  • Question (iii) What is the time limit for repaying this loan ?

Usually the maximum time limit allowed for repaying this loan is up to five years, except in the case you need it for your first home mortgage, when it is up to fifteen years.

  • Question (iv) What is the rate of interest ?

Usually it is about 1% above the prime lending rate. In 2017 the rate of interest is 4%. The reasonably lower rate is one of the prime attractions for borrowing from the 401(k) plan.

  • Question (v) What are the consequences of a delay in repayment ?

If you are unable to repay the loan from a 401(k) plan account and your age is less than fifty nine and a half years, then your loan will be treated as a withdrawal, on which you will be required to pay full income tax as well a 10% penalty for early withdrawal.

  • Question (vi) Whether your plan provides for any matching contribution from your employer ? Whether you will be allowed to continue to contribute to your 401(k) plan during the period when you are repaying the loan ?

This can have a major impact on your decision to borrow from the 401(k) account. If there is a provision of a matching contribution from the employer, then it would be usually preferable to continue with making contributions even during the period of repayment of an earlier loan, provided that the terms and conditions allow that.

Understand the Pros & Cons of borrowing from 401 (k) Plan

There are both benefits as well as losses in borrowing from 401(k) plans. Before one can take a decision, one needs to fully

understand all the implications.

Advantages of Borrowing from 401(k)

  • Getting the loan is usually a simple and expedient process, not requiring cumbersome formalities or procedures.

  • You can get the loan irrespective of your past credit rating.

  • The interest rate charged is usually low compared to other credits.

  • So far as you pay it back, there are no taxes or penalties for borrowing.

Disadvantages of Borrowing from 401(k)

  • By drawing out of the account, you restrict your earnings to solely the interest paid by you.

  • Some employers do not allow you to contribute during the repayment period. In such a case, you lose the matching grant that you would have got otherwise.

  • By borrowing you are losing on the returns on your investment. In addition, your whole retirement planning can also go out of hand, if you take frequent loans from 401(k) plan.

  • In case you fail to repay within the stipulated time, the amount not repaid becomes a withdrawal, and attracts regular income tax, in addition to a penalty up to 10%.

Taking the Decision about Borrowing

The most important step is to rationally decide as to whether borrowing from 401 (k) is actually in your interest. For this purpose, you have to consider all the relevant factors involved. You need to consider whether your need to borrow is dire enough to borrow from a 401 (k) plan. You also need to consider whether you will be able to repay the loan in time or not, because in case you are unable to pay, the cost of borrowing will be much larger. After considering all these facts, you need to take a decision whether it is worth borrowing from your 401 (k) plan.

Finally, Borrow

Once you have taken a conscious and well considered decision to borrow from the 401 (k) plan, you can borrow either by filling a paper form, making a telephonic request or by requesting through the internet, depending upon the provisions made in your plan.

Ensure Timely Repayment

Once the borrowing is done, you must make all possible efforts to repay the loan within the prescribed time limits to avoid the imposition of income tax and the 10% additional penalty. If you are able to repay the loan in time, the overall cost of borrowing will be significantly reduced. In that way, the returns on savings made for repayment of loan could be higher than any other investment option.

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