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401k Plan Loans
Allowing loans within a 401k plan is allowed by law,
but an employer is not required to do so. Many small
business just can't afford the high cost of adding
this feature to their plan. Even so, loans are a
feature of most 401k plans. If offered, an employer
must adhere to some very strict and detailed
guidelines on making and administering them.
The statutes governing plan loans place no specific
restrictions on what the need or use will be for
loans, except that the loans must be reasonably
available to all participants. But an employer can
restrict the reasons for loans. Many only allow them
for the following reasons: (1) to pay education
expenses for yourself, spouse, or child; (2) to
prevent eviction from your home; (3) to pay
un-reimbursed medical expenses; or (4) to buy a
first-time residence. The loan must be paid back
over five years, although this can be extended for a
home purchase.
Usually the participant is allowed to borrow up to
50% of their vested account balance to a maximum of
$50,000 (set by law). Because of the cost, many
plans will also set a minimum amount and restrict
the number of loans any participant may have
outstanding at any one time.
Loan payments are generally be deducted from payroll
checks and, if the participant is married, they may
need their spouse's to consent to the loan.
Funds obtains from a loan are not subject to income
tax or the 10% early withdrawal penalty. If the
participant should terminate employment, often any
unpaid loan will be distributed to them as income.
The amount will then be subject to income tax and
may also be subject to 10% withdrawal penalty. A
loan can't be rollover into an IRA.
There are generally four reasons given to avoid 401k
loans if possible:
* Lower investment return. According to the General
Accounting Office, the interest rate you pay
yourself on your plan loan is often less than the
rate your plan funds would have otherwise earned,
and you lose the benefits of compound interest.
* Smaller contributions. Because you now have a loan
payment, you may be tempted to reduce the amount you
are contributing to the plan and thus reduce your
long-term balance.
* If you quit working or change jobs, you must pay
back the loan right away. It's not uncommon for
plans to require full repayment of a loan within 60
days of termination of employment. If you don't
repay, the loan is considered defaulted, and you are
taxed on the outstanding balance, including excise
taxes in many cases.
* Repayment of principal and interest is made with
after-tax dollars. By contrast, a home equity loan
from a bank is often structured so that the interest
you pay is tax-deductible. On a larger loan, this
could add up to significant savings.
Go to www.401khelpcenter.com for more information on
this and other 401k issues.
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