You’ve maxed out your credit cards, are upside down on your mortgage and home-equity line, and many even have out a payday loan or two. You can’t just print your own money, right? Oh that’s right, there’s that 401(k) you forgot about, but a hardship withdrawal carries a tax penalty and requires time and documentation, both of which you don’t have. Chances are, like many Americans, you have exhausted traditional credit avenues and how nowhere else to turn. Well, think again about that 401(k) – if you have simply “ignored it,” you may be sitting on top of your own personal finance company.
Many financial advisors scream when one mentions the concept of “borrowing against” your 401(k) plan. It is an anathema to the concept of penny-pinching and thrift that embodies this method of retirement planning. However, when done correctly, such a loan can turn a lifeline when “all else fails,” into something which literally pays you back.
HOW IT WORKS: Most plans offer an option called “loan modeling.” This generally consists of three principal steps: qualification based on the amount in your plan, selecting the loan term, and acceptance of all terms and conditions of the loan itself. Here is a quick look at how the borrowing process generally works. Bear in mind, all plans vary, so consulting your plan administrator is a sound practice.
QUALIFICATION: Most plans do not require a credit-check for this loan because it is based entirely on collateral, which is the balance of your plan. The IRS places heavy restrictions on how these funds can be accessed and, consequently, almost all plan administrators require at least $1,000 available at the time qualification. Some require twice the amount requested to be available, with a minimum of $1000.
SELECT A TERM: This step is based entirely on what your budgetary needs allow. Most plans do not allow the term to be over 60 months (5 years) with some exceptions made for home purchases. The term decision also outlines the interest rate of the loan. This is where what seems like a liability can turn into an investment. While bank loans have interest paid directly to the bank, the interest on a 401(k) loan is paid, at least in part, directly back to the account from which the funds originated. Some plans require a portion of the interest to go towards fees to administer and service the loan, and rates can vary based on the market conditions, but are usually very competitive and in most cases, much lower than traditional unsecured personal loans.
ACCEPTING TERMS AND CONDITIONS: This is the stage where most people simply “click, click, click” to get their money. There are some considerations to account for. First, make sure the loan you are taking is something you can repay without it eating too much into your paycheck. These loans are backed by your 401(k) and, as such, a default treats the loan like an early distribution, which you must then claim on your tax returns for that year. Also, it is a good idea to make sure the company you are working for is one your plan to stay with, or the loan is one where you can repay via bank draft, or standard payment. If this is something you are comfortable with, the fund plan issues and mails a check, or deposits the funds electronically into the account you designate. Within a few pay cycles, the repayment process begins.
Keep in mind that many employers place rules not just on how much can be borrowed and the maximum repayment time, but also on what the money can used for. Some plans also require additional documentation if that’s what its contact with the employer stipulates. Regardless, when used responsibly and paid back in a timely fashion, this financial tool can be the lifeline that many never thought they had.
SOURCE INFORMATION: Vanguard Fiduciary Trust, ING Investments, Wells Fargo Investments, “What Are the Rules for 401k Loans?” – www.401planning.org.