Most companies allow their employees who use retirement plans like 401ks and 403bs to borrow from these accounts to pay for things that occur before the employee retires. These are not considered withdrawals, and the employee pays the loan back, with interest, over a short period of time. Employees like the idea of “borrowing from myself and paying myself back” and the ease of setting these loans up. However, a 401k/403b loan is a risky college finance strategy that does not always work. In part one of this blog, we’ll look at a few of the reasons why.
How do 401k/403b loans work?
Employees who want to set up a 401k/403b loan contact their 401k/403b manager. The manager sets the repayment terms, which include a five year repayment period (ten years if the loan is to purchase a primary home) and the interest rate. Employees pay the loan back through payroll deduction over 60 months. Most employers limit employees to one 401k/403b loan at a time, and some may not allow employees with outstanding 401k/403b loans from putting new money into their 401k. Most employers restrict the size of a 401k/403b loan to $50,000 or 50% of the balance of the 401k, whichever is smaller, though some have even lower borrowing limits.
Separation Anxiety: What happens if the 401k/403b loan borrower leaves their company, or is fired?
The first risk a 401k/403b loan borrower faces is that if they leave their employment, voluntarily or involuntarily, their loan can be “called.” The employee may be required to repay the loan within 30 days of leaving the company’s employment or else the remaining balance on the loan is converted into a withdrawal. If this happens, the employee will face an income tax obligation and a 10 percent early withdrawal penalty at time when they may be unemployed or dealing with the costs of changing jobs. Some companies allow 401k/403b loan borrowers to continue to repay their loan on its original terms, but these are not the majority.
The One Loan Rule:
Most college educations take two, four, or five years to complete. Since most employers limit employees to one 401k/403b loan at a time, employees cannot borrow as they need funds, but instead must decide whether to take the maximum amount allowed from their 401k/403b to pay for the most college possible. The employee might have to park those 401k/403b loan funds in an account until they need them, which in turn might make their assets look larger and cost the student some need-based financial aid early in their college career. If the total education costs more than the $50,000 withdrawal limit, the family might need a different loan to cover the additional costs.
Look for Part 2 of this topic next week!