How to talk to your clients about retirement plan loans

Should I take a loan from my retirement plan account? It’s rarely a good idea to dip into retirement savings, but some clients may insist it’s necessary to take a loan from a 401(k). If your clients are considering this route, you can help them understand the rules and the risks.

Whenever possible, the savings in a retirement plan account should be preserved for their intended purpose — to fund retirement. But if necessity or special circumstances lead your clients to consider taking a loan from a 401(k) retirement account, you can help them understand the big picture before they decide whether to go ahead.

Step 1
Explain the rules that apply to retirement plan loans.

Not all retirement plans offer loans as an option. Generally 401(k), 403(b), 457(b), profit-sharing and money purchase plans may offer loans (individual retirement accounts and IRA-based plans cannot). For those that do, specifics may vary from plan to plan, and your clients should check with their plan administrators or their plan documents for complete details. But these general rules may apply:
 

• Loan amounts are limited to half of the participant’s vested balance, up to $50,000, according to the Internal Revenue Service (IRS).
• Certain plans may have a minimum loan amount.
• The interest rate on 401(k) loans is often relatively low, about 1% to 2% above the prime rate. And participants pay the interest back into their own 401(k) account.
• Generally, loans must be paid back within five years. Home purchase loans may be extended longer.
• Some plans may only allow loans for specific uses, such as education expenses, medical expenses, housing costs or the purchase of a first home.
• Plans may limit the number of outstanding loans a participant can have at one time.
• There may be loan initiation and maintenance expenses.
• Participants can pay off a loan early.

Step 2
Explore the pros and cons of taking a retirement plan loan.

As retirement plan account balances grow, it can become more and more tempting to take a loan. You can help clients make better-informed decisions  by explaining some of the potential benefits and disadvantages of loans.
 

• Loan benefits:
  • Plan loans offer easy access to savings. A participant doesn’t need a credit check or a bank’s approval to apply for it.
  • The loan is not subject to income tax or penalties, as long as plan rules are met.
  • Borrow from yourself, pay yourself back. Payments made on the loan — including interest — are paid back into the participant’s account, not to a bank or someone else. Essentially, the money is returned to the person taking the loan.
  • If the participant misses a payment or defaults on the loan, it does not impact their credit score, but defaulting on the loan could result in taxes and penalties. 
• Loan disadvantages:
  • Taking a plan loan may leave a participant with less money at retirement. Unless participants are able to save more to catch up on missed growth opportunity during the time the loan amount was not in the plan, they may have less to live on in retirement.
  • Many participants tend to reduce their retirement plan contributions while paying back their loans. This can have a long-term impact on their future.
  • If participants with a loan balance leave their employers, they may have to repay the entire balance of the loan in full in a very short timeframe. If it’s not, the amount taken from the plan would be considered a distribution from the retirement plan, rather than a loan, and the participants will owe income taxes and an early distribution tax of 10% for those under age 59½.

Step 3
Help your clients decide whether a plan loan is the best way to meet their needs.

Once your clients understand the rules of retirement plan loans and have considered the pros and cons, help them think about whether a this type of loan is in their best interest.
 

• Why is the money needed now? If it’s to pay bills or take a vacation, then drawing on retirement money should be a last resort. After all, the money in this account is supposed to help support them in retirement — not today. It really comes down to how comfortable they are choosing the short-term gain of a loan over the long-term cost that could impact them during the years when they need the money most.
• Are there other sources of funding to consider? Explain how it may be a better idea to consider all other possible resources — family, friends, other accounts, even a traditional bank loan — before dipping into a retirement plan account.
• One possible alternative could be a hardship withdrawal from the retirement plan. The plan may allow a hardship distribution to meet certain immediate and heavy financial needs such as expenses for education, housing, medical care, or funerals. The money is taxed, but there’s a 10% early withdrawal penalty that participants under age 59 1/2 typically face. Because the money isn’t repaid to the plan, a drawback to a hardship withdrawal is that it may reduce the amount available for use during retirement.