Loans From 401(k)s: Be Careful!

By Joe Cicchinelli, IRA Technical Expert

Follow Me on Twitter: @JoeCiccEdSlott

Over the past several years, as the U.S. economy has been struggling, more employees have turned to their company 401(k) plans for a quick source of cash by taking loans from their plan balance. Many 401(k)s offer a loan feature, in fact some plans make it so easy for employees to get a loan that they offer a 401(k) loan debit card!

For employees that have a loan feature in their plan and are in need of extra cash, this can be an attractive option. However, plan loans are not a “no-strings attached” deal. Loans from a 401(k) plan must meet a variety of rules that must be followed. When the rules aren’t followed, serious tax consequences can happen. The company plan administrator is in charge of adhering to these rules.

In general, plan loans should be avoided for many reasons. 401(k)s are meant for retirement; not to finance a lifestyle that’s above your normal means. The funds that are borrowed are not growing because they’ve left the plan and are not growing on a tax-deferred basis. Also, the loan must be repaid; if not, you will be taxed on it.

Keep in mind that the loan is tied to your job. If, for whatever reason, you stop working for your employer, your entire loan balance will be due. If you can’t pay back the entire loan balance, that amount will be treated as a deemed distribution, which is taxable to you and subject to the 10% early distribution penalty tax.

While a 401(k) loan certainly has some benefits; be careful. Loans from a 401(k) should generally be avoided except during a genuine financial emergency.