Things to consider before taking a loan from your 401k

Before you take a loan from your 401k, consider this….

Why did you contribute to your 401k in the first place?

To save for retirement. 

This is an admirable goal – one that your future self will thank you for.  Many 401k plans do not allow you to make contributions while you have an outstanding loan.  This means that you may also be missing out on employer matching contributions – which means you could be turning down free money!

For the tax-deferred growth. 

When you take a loan from your 401k you aren’t taking a loan from the institution with your 401k as collateral.  You are literally taking the funds out of your 401k and then paying them back over time.  That means that you would be losing the potential tax-deferred growth on those funds while the loan is outstanding.

For the tax deduction or tax management. 

If you contributed to your 401k on a pre-tax basis, common with a traditional 401k, then you did not pay taxes on those funds when you contributed them.  When you withdraw the funds in retirement you will pay taxes on the original contribution and any growth that has occurred in the account but you don’t pay taxes annually on the growth (hopefully) occurring in the account. 

When you take a loan from your 401k, you take out the pre-tax funds you contributed, and then you pay those funds back with after-tax funds.  And then, in retirement, you pay taxes on all of the funds you withdraw, including those repaid loan dollars.

Another major consideration should be what happens if you separate from your employer with a loan outstanding against your 401k.  The 401k plan document itself sets forth the options for repaying the loan at that point.  In some cases, you’ll be able to continue paying off the loan in regular installments.  However, in other cases the loan may be considered a distribution immediately.

There is also the difference between the plan’s treatment of the loan vs. the tax treatment to consider.  If your plan forces the distribution treatment of the outstanding loan balance at termination, the IRS allows you to “pay it back” into a rollover IRA prior to the due date of your tax return without penalty.  However, this still means that you need to have the cash to put into the rollover IRA.

Another thing to consider is that, even if you are able to continue payments on an outstanding loan when you separate from your employer, that option is only available as long as you keep the 401k with the current plan.  If you choose to rollover the 401k to an IRA or to another plan, the outstanding loan amount will be considered a distribution.

Yes, there are times when a 401k loan makes sense or may be the only option.  However, I suggest that the 401k loan be considered in emergency cases or as a last resort. 

It is true that you’re paying yourself interest.  But you’re paying interest with after-tax dollars whereas, if you left those dollars in the 401k, they could be earning tax-deferred returns on your investment.  And, while the interest rate on a 401k loan may be low, that means you could likely have made a better return on those funds by keeping them invested.

Also, keep in mind, the employer does not have to approve a 401k loan.  So, you should not simply assume that the option is always available to you.  They don’t do a credit check, but they may use other factors in their decision such as the reason for the loan, your history taking loans from the 401k, or, if you’re near retirement or the end of a contract, they may question the ability to pay back the loan since regular deductions from your paycheck won’t happen after separation from the company.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

Retirement Planning Changes – Lot’s of Good News!

As part of the 2023 Consolidated Appropriations Act, the SECURE (Setting Every Community Up for Retirement Enhancement) Act 2.0 was signed into law on December 29, 2022.  The purpose of the act is to provide incentives for retirement savings.  It includes dozens of new provisions impacting businesses and individual retirement savers.

A great feature of many of these provisions is the increased flexibility with retirement funds.  One of our primary purposes in financial planning is to ensure that you have options in the future.  Many of these provisions make it easier to keep your options open.

 

RMDs Delayed until age 75

Required Minimum Distributions, RMDs, the distributions that you are required to take from qualified retirement plans when you reach the specified age, are now delayed until age 75 if you were born in 1960 or later.   Previously, under the first SECURE Act, RMDs were required at age 72. This delay allows your qualified retirement funds to potentially (hopefully) grow for a longer period of time without the headwinds of an annual income tax bill on those funds.

 

New Roth options

Roth contributions to retirement accounts are after-tax contributions, meaning that you do not take a tax deduction for them in the year that you contribute the funds.  However, the funds that you withdraw from your Roth account in retirement are not taxable (subject to some qualifying rules).  This means that the growth in those accounts is never subject to federal income tax*.

There are a few ways to make Roth contributions to your retirement savings including Roth IRAs, Roth 401k and Roth 457 accounts as examples.  However, not all employer plans include Roth accounts.  And, many people cannot contribute directly to Roth IRA accounts because their income is over the limit.  Plus, the limit for IRA contributions is pretty low to be the sole source of retirement savings.

SECURE Act 2.0 opens up additional options for retirement savers to build Roth accounts.  First, the act allows employer matching contributions to retirement plans to be designated to Roth accounts.  Prior to the SECURE Act 2.0 all employer contributions were required to be pre-tax contributions. And, for those who have SEP-IRAs or SIMPLE IRAs, Roth contributions are now permitted to these accounts as well.

One of the strange features of qualified employer plans that included a Roth component prior to SECURE Act 2.0 is that RMDs were required from the Roth component of those plans even though RMDs were not required from Roth IRAs.  One of the provisions of the new act eliminates the requirement to take RMDs from your employer plan Roth accounts.

 

Not all provisions of the act are effective right away.  And, these changes came about quickly so plan providers and custodians will need some time to set up their systems to accommodate these changes.  Also, these new provisions allow for this increased flexibility – they do not require that employers offer these new features.  As an example, even before the first SECURE act, relatively few employers offered Roth components in their 401k plans despite the fact that they were legally permitted.

 

Usual Caveats

While we appreciate the increased flexibility the SECURE Act 2.0 provides, there are still the usual caveats.  Everyone’s situation is unique and should be evaluated individually.  Just like this tax law introduced changes, a future tax law could introduce other changes.  Any tax law changes mean that your plan should be revisited.

*According to the current tax treatment of qualified withdrawals from Roth accounts.