How Does a 401(k) Loan Work, and is it the Best Option?
Offering your employees a 401(k) plan has numerous benefits to help them save for the future, including company-matched contributions and tax-deferred income.
If your employees are faced with a sudden financial emergency and they do not have the savings to cover it, or they need to readjust their finances, they may consider taking out a 401(k) loan to avoid future debt.
The Basics of 401(k) Loans
Like any financial decision, there are a variety of factors to consider when making your choice. Taking out a 401(k) loan is not something an employee should consider lightly. Here are a few quick facts:
- If a 401(k) plan permits a personal loan, employees are eligible for it at any time, though they are typically limited to one or two loans.
- Essentially, it means that they are borrowing their own money, so they are not required to complete a credit application.
- The amount they can borrow is mandated by the IRS.
- They may borrow 50% of their account’s balance, up to a maximum loan of $50,000.
- If the plan permits two loans, these guidelines apply to the total of both loans.
The Terms of 401(k) Loans
When an employee submits a 401(k) loan application, your company must provide them with the full repayment terms. Documentation should include the number of payments and the amount of each payment, as well as the interest rate.
The 401(k) loan must be paid off in full within five years, and the payments will be divided equally and include principal and interest.
Typically, as an employer, you will deduct your due payment from the employee’s monthly paycheck, though in some circumstances, you may be able to arrange a plan in which repayment is made less frequently. In this case, the payments must be made at least once each quarter.
The exception to this rule is when an employee is taking out a 401(k) loan to buy a primary residence. In this case, employees have the option to extend the terms of their loan.
A 401(k) Loan vs. Withdrawing your 401(k)
Taking a 401(k) loan is not the same as withdrawing money from a 401(k) retirement plan. Here’s why: when an employee withdraws their 401(k), this means that they cash out all the money and cancel their savings plan completely.
Although they do not have to pay the money back, they will have to pay a penalty fee of 10% if they are younger than 59 years and six months. They will also lose their retirement savings opportunity, which can set them back considerably.
In short, cashing out a 401(k) is not a good solution for a short-term financial problem.
A 401(k) loan allows employees to borrow a sum from their retirement accounts, without closing it. This option allows employees to borrow from their savings (with restrictions) and pay themselves back over time.
The Advantages and Disadvantages of 401(k) Loans
Although 401(k) loans can provide a cost-efficient way to borrow money, there are advantages and disadvantages to consider before employees apply.
- Taking out a 401(k) loan can be a good option because employees do not have to make a loan application that requires a credit check. This means that no minimum credit score is required. The 401(k) sponsor will make automatic paycheck deductions over the allocated period of the loan, making it easy to repay the loan.
- When employees compare 401(k) loans to more traditional ways of borrowing money, they will find that they can be more cost-effective. For example, employees are not paying interest to a lender; they’re paying it into their own account, which can make for a better option than other lines of credit.
- Because employees don’t have to go through a credit application, and they are borrowing money from their own savings account, they can get their hands on the money quickly. In most cases, they may even be able to have access to the money within a week.
- When an employee takes out a 401(k) loan, the money they borrow is no longer invested. This means that they could lose several years of investment growth in their retirement savings. There’s no way that they can calculate in advance how much they might gain on their investment during the terms of the loan, but it’s important that they know they are going to miss out on a potential gain.
- Should an employee, for any reason, miss a payment on their 401(k) loan, and the loan goes into default, they will be required to pay income tax on the total amount of the remaining loan balance. This can worsen their current financial crisis.
- If an employee leaves their current job while they are still making loan repayments on their 401(k) loan, they will have to pay back the remaining loan balance in full. If they do not have the funds on hand to do so, they will have to pay income tax on the remainder of the loan, just as they would if the loan was to go into default. Employees may be able to avoid this if they are able to roll over the balance of their 401(k) loan into another eligible retirement savings plan before the filing date for their federal income taxes for that same year.
An Alternative to a 401(k) Loan
If your employees need a loan to help with an emergency financial hardship, such as car repairs, unexpected medical bills, or general day-to-day expenses, a 401(k) loan may not be the best option for them. If your company is eligible, you can offer TrueConnect loans, which may serve them better, particularly if they are looking to borrow an amount less than $3,000.
TrueConnect offers a safe and affordable alternative to 401(k) loans and payday loans for employees who need resources to help them through a financial crisis. No credit check is needed to qualify, and borrowers are also eligible for up to six free financial counseling sessions to provide them with tools and skills to help them better manage their finances.
All borrowers receive the same interest rate on their TrueConnect loans, and repayments are made through monthly automatic paycheck deductions over the course of one year. This means that employees do not have to lose any savings or gains on their 401(k) retirement plans.
If your employees are struggling with financial difficulties and they need to borrow money but do not wish to affect the current status of their 401(k) savings plan, a TrueConnect loan could be the perfect solution. TrueConnect loans are originated through a nationally chartered bank, at no cost to the employer. Contact TrueConnect today to find out how you can support your employees through their financial hardship and help them maintain their financial wellness.