COVID-19 Notes: 401(k) Loans Under the CARES Act

As the COVID-19 crisis continues, the severity of the economic impact on households is becoming clearer and more widespread. For some, the impact may be prolonged. As the ability to postpone creditor payments diminishes over time and emergency savings whither, it would only be natural to wonder if you should consider borrowing from your future. That is, taking a loan from your workplace retirement account, such as a 401(k), 403(b) or 457(b) account.

The March 2020 CARES Act anticipated this decision. Per the Act, the amount that you can borrow from your workplace retirement account was raised to $100,000 and can be up to the full balance of the account. And for previous outstanding loans (loans entered into before the enactment of the CARES Act), payments due this year can be postponed for up to a year.

Importantly, these new rules only refer to“qualified individuals.” As the law is written, the only person who can take advantage of these special provisions is a person who is diagnosed with COVID-19, has a spouse or dependent who has received a diagnosis or is personally affected by the resulting economic downturn.

If, for example, a husband loses his job or his wages are reduced due to the economic downturn, the loan cannot come from his wife’s retirement account and benefit from these new provisions. Non-qualified individuals, of course, can still take out a workplace retirement account loan under the old rules which limit loans to $50,000, and cannot exceed one-half of the account balance.

The Real Question

So, we know that you can take a loan from your retirement account. But should you? First, a primer on how retirement account loans work. When you take a loan from your retirement plan, you pay it back automatically through a payroll deduction. This means that you can only take a loan if you are currently employed; you cannot take a loan from an “old” 401(k) (or similar) account with a previous employer. The period of the loan usually cannot exceed 5 years.

Pros:

Interest is charged, usually just a few points above the prime rate, however this interest payment flows back into your account. Compared to alternatives such as using a credit card, the cost of a workplace retirement account is often less. As well, the process for obtaining a loan is generally easy and does not require a credit check.

But there are some downsides, which can be quite significant:

• If you leave your employer, the outstanding loan balance is treated as a withdrawal. If you are under the age of 59 ½, this means that you will pay a 10% penalty as well as income tax on the amount withdrawn. (This does not seem to have changed under the CARES Act.)
• Quite obviously, you are losing the tax-advantaged investment return on the money you have withdrawn while it is out of the account.
• And while the loan is outstanding, most employers will not allow you to make new contributions to your account, and so you will lose the ability to increase your tax-advantaged retirement savings for several years. Not only are you losing the earnings on the money that you removed from the account, you are losing the earnings on money that you would have invested during this time. But, realistically speaking, you may have already suspended new contributions in order to increase your take-home pay and so this may not feel relevant to you, at least in the short term.

The decision to take a 401k loan can be a difficult one to make.

How should you weigh the pros and cons?

• Consider the effect on your cash flow. Payments will be automatically deducted from your paycheck. Can you afford that? Find out from your plan administrator what your repayment will be before you make the decision. Frankly, if you are qualified to do so because your income has been reduced, it may be that you are better served by taking a penalty-free withdrawal under CARES rather than a loan.

• Do you have a lower cost alternative? If your household income and creditworthiness is still such that you can tap a low interest personal loan, that may be a better alternative when you consider the full opportunity cost of the retirement account loan. There are a number of online calculators (for example, here) that you can use to judge the true cost of a 401K or 403b loan.

• Do you feel that your job is vulnerable? If the loan turns into a withdrawal, as mentioned above there will be a significant penalty. (While the CARES Act has suspended penalties for early withdrawals by qualified individuals, it is unclear if this applies to withdrawals as a result of unpaid loans.)

• Is it foreseeable that your situation will reach a point such that you will consider personal bankruptcy? Your retirement accounts are protected in bankruptcy. It would be a shame to drain your retirement account, only to later have to file bankruptcy anyway.

The decision to take a loan from your workplace retirement account is not a decision to be made lightly. It is quite literally a loan today from your future self that can impact your retirement security later. However, in times of financial stress, this may be the bridge that you need to stability.