Wednesday, December 4, 2024

Dear Dollar Stretcher,
I would like to provide a loan to a friend from my 401k plan. What are the rules? How do I go about making this type of transaction? What are the guidelines for re-payment?
--George S.

Now that's an interesting question! And it must be an interesting friendship, too.

Before we consider whether it's a good idea, let's take a look at how 401k loans work. A majority of all private sector workers have a 401k plan available to them. They can set aside a portion of their pre-tax wages and put them into the plan. Some companies will also make a matching contribution. The contributions and any earnings are not taxable until the employee takes the money out of the plan. Because taxes aren't collected each year, money in a 401k grows quickly.

Federal law allows for employees to 'borrow' the money from their 401k. Loans are limited to 50% of the account balance or $50,000 (whichever is less). About 80% of 401k plans allow for loans. Some don't because it's expensive for them to keep track of loans and do all the necessary bookkeeping. The plan administrator can charge service fees on loans. Some charge a one-time 'origination' fee. Others will charge a fee each year that the loan is active.

Most plans will let you borrow for any purpose you want. But some only allow loans for specific purposes like buying a house.

Since it's a loan, the money needs to be paid back with interest to the 401k plan. By law the interest rate that you pay must be competitive. The plan administrator will set the interest rate.

Generally, loan repayment can be scheduled for up to five years. Most plans use payroll deduction for repayments.

Now let's look specifically at George's situation. Should he take out a 401k loan and then lend that money to his buddy? In every circumstance that I can conceive it would be a bad idea. And in some situations it could be a VERY bad idea.

First, if George should have an emergency situation he will not have these funds available. What happens if he has a medical emergency and needs to borrow money from his 401k? If it's already loaned to his friend, it won't be there when he needs it.

George could also find himself tied to his current job because of the loan. In most cases loans must be fully repaid immediately if you leave your job. So George couldn't change employers if he wanted to.

Worse than that, if he was laid-off the entire loan would need to be immediately repaid. If George can't do that and he's under age 59 1/2 he'd face a 10% penalty on the outstanding loan. And the loan amount will be added to his taxable income this year. George could find himself in the rotten position of losing his job, being forced to pay taxes on money from his 401k plan that he doesn't even have, and needing the money from the plan but not being able to get it from his friend.

Payments could also be a problem. Payroll deduction will continue whether George collects from his friend or not. Should George's friend miss a payment, George could find himself facing a crisis in his own finances. Any loan to his friend should be written up legally with a clear repayment schedule and rates for interest and penalties.

And, even if things go well, George could face a hidden expense. It's very possible that the investments in the 401k could have earned more than the interest rate on the plan loan. Because it's in a retirement account the money that he loses this year will be multiplied by the time he retires. For instance, if George is 30 years old, every dollar he loses today could mean a loss of $32 at retirement.

Finally, George needs to consider whether this is good for his friendship. If the friend is a good credit risk they shouldn't have trouble borrowing the money somewhere else. So there's no need for George's money.

If, however, the friend is being turned down by professional lenders, there's a good chance that George will not be repaid. Generally friends that can't repay loans don't remain friends for long.

If the friendship breaks up because George isn't willing to make the loan, it's not much of a friendship. Certainly not good enough to justify George taking the risks to make a 401k loan.

Finally a word of personal advice. I applaud George's willingness to help his friend. He's to be admired for that. But, more than one friendship has been lost because of borrowed money.

There is one guideline that George could use. If he's willing to lend his friend the money with the expectation that he will NOT be repaid he should make the loan. That means that he's willing to accept that he won't see any of the money again.

It sounds funny at first, but think about it. If he doesn't expect to be repaid he must be in a situation where he can afford to make the loan. And because he doesn't expect to get the money back his friendship won't be hurt if that happens.

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