Is a 401(k) Loan in the Client’s Best Interest?
Planners can use the three checklists to guide them when counseling their clients about whether to borrow, and whether to borrow using plan loans. The decision often comes down to not allowing debt to sacrifice future security in retirement and finding ways to mitigate adverse consequences of taking a plan loan. Both of these trouble spots can typically be overcome with proper planning.
Checklist 1: Should the Client Take a Loan?
| Consideration | Comments |
| Is the loan frivolous or justifiable? | Avoiding debt is typically preferable, but not always possible or desirable. Loans can give a client financial flexibility. |
| Is the loan preferable to a hardship withdrawal? | Because of the tax consequences, the loan is typically a better alternative. However, if repayment is a problem, then the hardship withdrawal might be advantageous. |
Checklist 2: Plan Loans versus Commercial Loans
| Consideration | Plan Loan | Commercial Alternative |
| Is the application process simple? | Yes | Probably not, but it may not be onerous. |
| Is the client eligible for the loan? | Yes | Probably, but in some cases a credit check may make the client ineligible. |
| Can the client avoid the need to offer collateral? | Yes | Probably not, but some loans convey their own collateral, while others require much more substantiation and verification. |
| Are funds available in a timely manner? | Yes | Depends; some commercial loans have a drawn-out application process that delays access. |
| Are transaction fees low and reasonable? | Yes | Depends; many commercial loans have more expensive fees. |
| Does the client pay the interest to him/herself? | Yes | No; this can lower net worth and can be a major disadvantage of a commercial loan. |
| Does the loan provide a lower interest rate? | Yes | Depends; many commercial loans have higher rates of interest. |
| Can the client avoid lowering their credit score? | Yes | Depends; some commercial loans adversely impact the credit score. |
| Can the amount to be borrowed exceed $50,000? | No; plan loans are generally limited to the lesser of one-half the vested account balance or $50,000. | Yes |
| Is the loan re-payment schedule negotiable? | No; if the client needs more than 5 years because of large payments this can be a substantial disadvantage, even though longer payback periods cost more in interest. | Yes |
| Does qualified plan bankruptcy protection apply to the loan? | No; it is unwise to take a loan to stave off bankruptcy and then declare bankruptcy. | Not applicable |
| Can the client avoid the need to repay in full if a change in employment occurs? | No; this can represent a major disadvantage of plan loans. | Yes |
Checklist 3: Additional Considerations When Determining the Suitability of a Plan Loan
| Issue | Planning Consideration |
| What is the effect of having plan funds “out of the market” during the repayment period? | Planners need to illustrate to the client the potential impact of forgone revenue. Perhaps the client can rebalance the portfolio so the loaned funds are only affecting the part of the portfolio that would not be subject to significant market increases. |