401k loans allow you to borrow against your 401k account tax-free (as long as you pay it all back). The loan payments typically occur by payroll deductions. If considering a 401k loan you should carefully consider he loan terms and the ramifications. Your employer does not have to offer 401k loans and can severely limit what options are available to you.
Dallas employment attorney explains the types of 401k loans
There are two types of 401k loans available: general loans and home loans. General loans, by law, may only extend for the maximum of five years; but you can take out these loans for any reason (or no reason at all). Home loans are available to purchase a primary residence – and you may have to show proof – but they allow you to amortize the loan up to a maximum fifteen years by law. Many plans limit the length to a maximum of ten years.
IRS regulations calculate loan availability as the lesser of: 50% of the vested balance; or $50,000 minus the highest outstanding loan balance within the past twelve months. Be forewarned, loan availability is frequently under-calculated by large recordkeepers. If you need to take out a large loan and you have loans in the prior twelve months, you may need to calculate your loan availability on your own to double check the recordkeeper’s math before you process a loan.
401k loan payment responsibilities
The payments occur as after-tax payments, whether you write checks to the plan or by deduction from your paychecks. These payments include interest, which returns to your account. The after-tax payments convert to pre-tax when applied to your account and taxed again (unless Roth 401k assets) when withdrawn. As a result, taking a loan can be disadvantageous from a tax perspective. If your 401k is all pre-tax then you will be double taxed on the interest because you paid tax on the money before it went into the plan as a loan payment and you will pay taxes again when it is withdrawn.
If your 401k is Roth and/or after-tax, then you will be double taxed on the principal amounts because it was taxed as a contribution and then taxed again as a loan payment back to the plan but the interest will only be taxed once. You may want to consult a tax adviser to determine how a 401k loan might affect your taxes.
What happens if you don’t pay the 401k loan
You are responsible for the loan payments, no matter what. Your employer may agree to deduct payments from your paychecks but if your employer fails to deduct payments or delays deducting payments you may end up delinquent on the loan. If you do not keep the loan current it can default and become a taxable distribution to you. So you will owe income tax, and if you are under 59 ½ years old, likely the additional 10% penalty. The responsibility is yours. If you do take out a loan you need to make sure those payment deductions begin at the right time.
Keep in mind, that loan amount becomes earned income. It may increase your tax bracket and add substantially to your tax bill (by both increasing your tax rate and making some deductions and credits unavailable).
Financial concerns about 401k loans
In addition to the tax consequences, there are several financial concerns to consider with a 401k loan. For one, you take money away from your investments. Any gains you could have received are lost. Certainly in a down or turbulent market that may not be a substantial concern but studies do show that on balance people who take out 401k loans end up with less market returns than those who left their accounts untouched over time. Additionally, the obligation for the loan payments may squeeze your finances in a bad way. If your payments are payroll deductions, employers will not stop those deductions even if you cannot afford the payments. Even bankruptcy, in many instances, cannot stop your obligation to repay the plan.
Other 401k loan concerns
Additionally, if you leave your job, you still owe payments on the loan. Most employers do not allow you to continue making payments. You will have to choose between paying it off or let it default and become a taxable distribution. Additionally, your plan likely only permits you to take out a certain number of loans in a given time period. If you take multiple loans you may find yourself in need of another loan but unable to do so. Given your plan terms and individual financial situation, there may be many other financial concerns to consider.
Many financial advisers recommend against taking 401k loans as financially detrimental. Before taking a 401k loan, carefully consider your situation and speak with a financial planner and/or tax adviser.
If you believe your 401k plan administrator failed to follow its plan rules then you should contact an employment attorney in Texas to discuss your concerns. Federal law protects your rights under a 401k plan and provides remedies when a 401k plan violates employee rights.