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SPOTLIGHT ON EMPLOYEE BENEFITS (July 2009)
Our dedication to you is driven by a motivation to always do what's in your best interest. Part of that includes providing you with information so you have more control of your financial future. We've chosen several topics below that we feel will be valuable to you and your associates.Web Address Update
Over that last several months, we've been providing our clients with a direct link to their benefit plan login. The address is http://www.yourplanaccess.net/redw. Saving this address as your favorite will avoid disruption in your ability to log in to your account.
A Few Things To Consider Before Taking A 401 (k) Loan
Retirement plan loans are emerging as a popular financial resource for families as they attempt to cope with the strain of a worsening economy. Before participants borrow from plan assets, the long term consequences of the loan should be considered and compared to traditional borrowing.
An investment in yourself, as some will assert, plan loans provide participants a convenient and quick solution to immediate money woes; where the interest is paid to the retirement account, rather than to a bank or credit card company. A guaranteed, positive rate of return in today's market is attractive, especially after watching 401(k) account balances drop 30% or more.
Does this sound too good to be true? Perhaps it is. Just over half of all 401(k) plans make loans available to employees, according to the Employee Benefit Research Institute (EBRI). Many employers add a plan loan feature to boost participation in their plans, because employees are more likely to save money if they know they can access it in an emergency. Let's review some plan loan basics:
1. The maximum loan amount a participant may borrow is generally 50% of the vested account balance, to a maximum of $50,000.
2. Loan repayments are generally required via payroll deduction.
3. Interest rates will vary by the plan, but the rate most often is tied to the "prime rate".
4. Funds obtained from a loan are not subject to income tax or the 10% early withdrawal penalty (not including loan defaults discussed later).
5. A 401(k) loan can't be rolled over to an IRA.
6. The participant can repay the loan at any time with no penalties.
7. In some plans, spousal consent may be required.
8. Plan loans are a plan feature. The sponsoring employer is permitted to incorporate loan minimums and eligibility restrictions provided they are on a nondiscriminatory basis and in accordance with published guidance.
But what are the drawbacks to taking a plan loan? Stringent repayment schedules, significant tax consequences, loan fees, and loss of investment earnings make borrowing from a 401(k) account an option that requires careful consideration.
401 (k) LOAN PITFALLS
Opportunity Cost
Borrowing from a 401(k) can have a drastic effect on the future balance of the account at retirement, especially if contributions stop while the loan is repaid.
Consider this hypothetical example of how a loan can impact retirement savings. Participant Mary is 40 years old, earns $50,000 a year, and has a 401(k) balance of $30,000. She contributes $3,000 a year (6% of her salary) to her account, and her employer contributes $1,500 (3%). If she continues saving at this rate until age 65, her 401(k) balance will be approximately $447,443, assuming an average annual rate of return of 7% on her investments. Mary wants a new car. She takes out a $10,000 loan on her 401(k) and repays it over five years, at an interest rate of 5%. However, Mary, like most participants, can't afford to make her regular 6% contribution in addition to her loan payment. She stops making her regular contribution for the duration of the five year loan. Assuming the same rate of return, Mary's account will be approximately $355,585 at age 65.
That difference of $91,858 translates into a loss of $5,511 a year in retirement income, assuming a post-retirement rate of return of 6%. That's over $450 a month!
Double Taxation
Another point that's often overlooked is the double taxation of the loan principal and interest amount. The money borrowed from a 401(k) is pre-tax money. And unlike pre-tax contributions, loan payments are includable in taxable income for the year; that is, they are paid with after-tax dollars. Subsequently, when the funds are withdrawn at retirement, they are subject to tax once again.
Reduced Contributions
As the example with Mary illustrates, stopping regular contribution to repay a loan will have a drastic effect on the future account balance at retirement. Employees looking to 401(k) resources are most likely doing so because they have a need that cannot be met with personal savings, and they are not in the position to further reduce their take-home income. Consequently, many of these employees will be less likely to contribute the same amount to their 401(k) plan as they were prior to taking the loan, since they now have the additional burden of making an after-tax loan payment.
Default Risk
If the participant terminates employment or changes employers, the loan must be paid back promptly. It's not uncommon for plans to require full repayment of an outstanding loan within 60 days of termination of employment. If the participant is unable to repay the loan, it is considered in default. The outstanding balance becomes taxable income for the year. In addition, an early withdrawal penalty of 10% applies if the participant has not reached age 59 ½ at the time of the default.
AS A LAST RESORT
From time to time, real financial emergencies can strike anyone. However, it's important that participants clearly understand the long term financial consequences when borrowing from a 401(k) plan.
At REDW, integrity counts. We are in the business of solving problems for our clients and working with them over the long term to ensure their growth and prosperity. If you have any questions regarding the articles in this newsletter, please do not hesitate call me directly at (505) 998-3223 or toll-free at (877) 516-7339.
Sincerely,
Shannon R. Sietmann, CPC, QPA, QKA
Benefits Consultant