Several years ago, John and I were approached by a client and business owner with the following comment, “I want to close our 401(k) plan.”
Of course, our question was “Why, it is such a positive benefit for you and your employees?”
The answer was a bit surprising. “We have about 150 employees and many of our employees consider their 401(k) account like a bank account.”
“They constantly want to borrow from it. We are like a private bank. We have to calculate the loans, set up a payroll repayment plans and monitor the collection. We are sick of it.”
Retirement plans should not be considered a bank account. There are important issues to consider when borrowing from a plan.
There are limitations on plan borrowing.
Usually, a participant can only borrow up to 50 percent of their vested account to a maximum of $50,000. Also, the loan must be repaid. Most withdrawals are structured as a loan and have to be repaid within 60 months plus interest.
While the money is withdrawn as a loan, it is not earning the normal investment return since usually the interest charged on the loan is low, like 2 to 3 percent.
Most retirement plans are invested in a combination of investments that over the long term will have a better return than the loan interest charged.
Any loan that is not paid back within the terms of the loan is considered a distribution and subject to income tax and possible tax penalties.
While a loan may appear to be a convenient source of funds for various reasons, it may be a dangerous trap.
Most employers allow a payroll deduction for the loan payments to be withheld from the employee’s take-home check. The withheld amount represents the payback requirement.
In some cases, employees feel like they have no choice but to borrow from their retirement plan due to medical bills, high-interest debt or other unexpected expenses.
This step should be considered an emergency withdrawal and not a means of financing a liability or purchase.
Remember, if you do take a plan loan and you leave the employer for whatever reason, the loan is considered plan distribution and you must repay the loan within 60 days or face the ordinary income tax and penalties.
All of these issues underscore the need to build an emergency fund. Having adequate cash on hand for sudden financial crises can protect you against the complexities of borrowing from a retirement plan and all of the negatives aspects of plan loans.