In 2023, earning a guaranteed 7.5% on your 401(k) plan investment with no risk seems almost too good to be true. Here is the thing – it is not. What if I told you that you can generate a 7.5% annual rate of return for your 401(k) plan and you would get tax- and penalty-free use of the funds. All of this is possible thanks to Internal Revenue Code (IRC) Section 4975(d)(1).
By way of background:
IRC Section 72(p) allows a 401(k) plan participant to take a loan from his or her 401(k), so as long as it is permitted pursuant to the business’s 401(k) plan documents. Furthermore, IRC Section 4975(d)(1), exempts a 401(k) loan from the IRS prohibited transaction under IRC Section 4975(c).
A 401(k) loan is permitted at any time using the accumulated balance of the 401(k) as collateral for the loan. A plan participant can borrow up to either $50,000 or 50% of their account value – whichever is less. This loan has to be repaid over an amortization schedule of five years or less with payment frequency no greater than quarterly. The interest rate must be set at a reasonable rate of interest. The lowest interest rate permitted to be used for the loan is the Prime Rate, as per the Wall Street Journal, which, as of January 30, 2023, is 7.50%.
The beauty of a 401(k) loan is that the plan participant can get free reign of the funds for any purpose, and the plan will receive the interest from the loan. With interest rates increasing, the plan can now receive a significant return on the loan investment without risk, since the loan payment is being paid back by you. Of course, one must be careful to pay back the loan on a timely basis. If the loan payments are not made, the outstanding loan amount would be subject to tax and a 10% early distribution penalty if the plan participant is under the age of 59 1/2.
How does the 401(k) Plan Interest Work?
A 401(k) plan loan is a straight-line maximum five-year loan. In other words, interest and principle are combined to make up each loan payment. For example, a five-year, $10,000 loan would have a monthly interest payment of $118.80 for a total of $4,244.41 interest paid over the course of the loan. The individual would get $10,000 to use for any purpose, plus the plan would get a guaranteed rate of return of 7.5% annually.
Most 401(k) loans do not include a prepayment penalty. Moreover, a plan participant can technically elect to use a higher interest rate, even more than the 7.5%, but one must be mindful of your state’s usury rules. Selecting a higher interest rate would allow one to generate even higher returns for the plan. Don’t forget to pay back the loan, because if you default, that money can no longer be returned to the plan, and will be considered distributed; applicable tax and penalties will be taken.
Pros and Cons of the 401(k) Plan Loan
The main advantages of taking a loan from a 401(k) plan are as follows:
- Ability to get quick access to cash.
- Lower interest rate – Prime Interest Rate is currently 7.50% as of January 30, 2023 – much less than a credit card or pay day loan.
- Interest is being paid back to your 401(k) plan – helping increase the value of your plan. For example, a $50,000 loan at 7.50% interest will give your plan an extra $21,221.06.
- Ability to pay a higher interest rate on the loan, allowing one to increase the value of the plan, while gaining the ability to use loan funds for any personal purpose.
There are a couple of disadvantages to the 401(k) loan:
- Failure to pay back to loan will result in a taxable distribution and a 10% early distribution penalty if you under the age of 59 1/2.
- Money you pull out for the loan will no longer grow tax-deferred.
Studies show that many people have a problem paying back the loan and there is a relatively high delinquent rate. Also – when one changes jobs the loan will become due.
Is There a Difference between a 401(k) Loan and a 401(k) Withdrawal?
A loan and a withdrawal are two very different things. When you borrow money from the plan, you are required to pay it back. Conversely, a withdrawal is when you take money from the plan with no intention of re-contributing those funds. Another major difference is when you can access those funds. Again, assuming the plan docs allow for a loan, you can take one at any time. However, you generally cannot withdraw 401(k) funds without a plan triggering event. There are certain instances where you can qualify for a hardship distribution, although you don’t have free reign with those funds.
Lastly, there are taxes and penalties when withdrawing from the plan. When you withdraw any funds from a traditional 401(k), the amount distributed is taxable during the year they are taken. Plus, if you are under age 59 1/2, you will owe the 10% early withdrawal penalty. When taking a loan, there are no taxes or penalties unless you default on paying it back. And again, the interest you pay back actually helps increase your plan balance.
Read this: 401(k) Loan vs. Taxable Distribution
7.5% Annual Rate of Return
One of the advantages of a high interest rate environment, is that the interest payable from the loan will be much more significant for the plan investor. Of course, a lower interest rate means a lower monthly/quarterly loan payment, but it also means a lower annualized rate of return for your 401(k). The ability to pay that 7.5% interest back to yourself is quite appealing; much better than paying a higher rate to a bank or other lender. Plus, there’s no credit check or any other hoops to jump through. Obviously, the only caveat is that the plan allows for the loan.
Nowadays, it’s hard to guarantee a solid rate of return on your investment. With high interest rates and a slow economy, one should be looking at ways to build up your nest egg. Taking a loan from your plan may be a good option in the long run during these chaotic times. Just make sure you can repay the loan in the time allotted.
