Pros and Cons of 401k Plans

I want to cover one of the biggest issues in 401k plans, and that is loans. Making loans available within a 401(k) plan is allowed by law, but an employer is not required to do so. Regardless let's look at the pros and cons of loans.

401(k) Loan Basics

1. Assuming that you have had no other 401(k) plan loan in the last 12 months, you are allowed to borrow up to 50% of your vested account balance to a maximum of $50,000.
2. Loan payments are generally deducted from your payroll checks.
3. The interest rate will vary by plan, but the rate most often used is what is termed the "prime rate" plus one or two percent. The current "prime rate" can be found in the business section of your local newspaper or the Wall Street Journal.
4. Funds obtained from a loan are not subject to income tax or the 10% early withdrawal penalty (unless the loan defaults).
5. If you should terminate your employment with the plan sponsor, often any unpaid loan will be distributed to you as income. The amount will then be subject to income tax and may also be subject to 10% withdrawal penalty.
6. A 401(k) loan can't be rolled over to an IRA.
7. You can always repay your loan at any time with no penalties.
8. In some plans you will be required to obtain the consent of your spouse before you can obtain the loan.

The Pros:

1. It's convenient. There is no credit check or long credit application form. Some plans only require you to make a phone call, while others require a short loan form.
2. There is a low interest rate. You pay the rate set by the plan, usually one or two percentage points above the prime rate.
3. There usually are no restrictions. Most plans allow you to borrow for any reason.
4. You are paying the interest to yourself, not to the bank or credit card company.
5. The interest is tax-sheltered. You don't have to pay taxes on the interest until retirement, when you take money out of the plan.
6. You choose where the money comes from. The advantage of being able to choose which investment option you will sell in order to obtain the funds for your loan is that you can leave untouched those investments with the best performance.

The Cons:

1. There are "opportunity" costs. According to the U.S. General Accounting Office, the interest rate paid on a plan loan is often less than the rate the plan funds would have otherwise earned.
2. 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 retirement account balance.
3. Loan defaults can be harmful to your financial health. If you quit working or change employers, the loan must be paid back right away. It's not uncommon for plans to require full repayment of a loan within 60 days of termination of employment. If you can't repay the loan, it is considered defaulted, and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½.
4. There may be fees involved.
5. Interest on the loan is not tax deductible, even if you borrow to purchase your primary home.
6. You have no flexibility in changing the payment terms of your loan.

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