|Gary Foreman is a former Certified Financial Planner (CFP) who currently writes
about family finances and edits
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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?
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
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
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
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
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