| Ted's Table |
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October 23, 2001
My employer wants to change the terms of my 401(k) loan. Can it do that? ... I have a 401(k) loan and am paying a 6.5 percent interest rate, but market rates are now lower. Is it worth refinancing the loan to get a lower rate? ... Are 401(k) loan repayments taxed twice? ... Since my 401(k) balance has fallen 12 percent in the last year, should I reduce my contributions and use the extra income to pay off bills?
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TB: Before I answer this week's questions, it's time
to chew on some crow. In my last column, a reader asked what could be done with 401(k)
money of a former employee who couldn't be located. I said the reader needed to find the
employee, but if that were impossible the benefits would go to the state. The laws
governing this transfer are called "escheat" laws, as a sharp-eyed reader, David
Vail, wrote in. So, it is with great humility that I admit I es-cheated you readers by
improperly using "eschew."
Q: In 1992 I took out a $40,000 loan to be used as the
down payment to buy a home. The term of the loan was 20 years, payable at $322.24 per
month. When I took out the loan I worked for Company A. Company A was then bought by
Company B; subsequently, Company B was bought by Company C. Currently, the 401(k) plan I
had with Company B is separate from the Company C plan, but next year the two should be
combined. Company C recently informed me that my original 401(k) loan does not comply with
its loan guidelines. They have changed the terms of the loan to comply. It will be a new
loan based on my remaining outstanding balance and with a 10-year repayment schedule. Do
they have the grounds to do this?
TB: Your employer apparently thinks your loan is not
in compliance with the applicable IRS regulations. It is required to do whatever is needed
to get the loan in compliance. Failure to do so could jeopardize the tax-qualified status
of the plan and create a taxable event for you. Company C should re-amortize the loan so
that it will be fully paid within the 10-year time period. This is what it appears they
are doing.
Q: I currently have a loan from my 401(k) with a 6.5
percent interest rate. It was a four-year loan and the end of December will mark the
repayment halfway point. I currently pay $327 biweekly to repay the loan. Currently,
market-based interest rates are 4.875 percent. Would I be wise to refinance the loan at
the lower interest rate for those last two years? How much lower would my biweekly
payments be? Money is tight and the extra cash would really help my budget.
TB: What you are permitted to do will depend upon
the rules that your employer has established for administering loans. To accomplish your
goal, you will probably have to repay the remaining balance and then take a new loan at
the lower rate. This will probably result in you being charged a new loan implementation
fee if you are permitted to do this. You will also have to find the money to pay off your
outstanding balance until you can get the money from the new loan. For example, assume
your loan balance is $10,000. You will probably have to repay this amount then apply for a
new $10,000 loan.
The company that administers the plan will have to tell you
whether this is permitted and they will have to determine the amount of the new loan
payments. I suspect the reduction in your loan payments will likely be pretty small.
There's one other point you might want to consider. In most
cases, the interest you pay on your 401(k) loan goes back to your account and continues to
work for you. The 6.5 percent interest rate you are paying now is actually a better return
on your investment than you can get with many other vehicles.
Q: I have been discussing with co-workers whether or not
loan repayments are taxed twice — once on repayment and a second time at
distribution. Is this true? I have also heard that only the interest portion of the
repayments are taxed twice. What is the real answer?
TB: Yes, both the loan payments and the interest are
taxed twice — once when the loan is repaid and again when it is received as a
distribution from the plan. You pay taxes the first time because 401(k) loans are repaid
with after-tax dollars, not pre-tax dollars. You repay with after-tax dollars because you
already got a tax benefit once, when you deferred salary on your original contribution.
You aren't entitled to another tax break on the salary deferrals used to repay the loan.
I came to the conclusion recently that hardship withdrawals
are generally better than loans for most employees. I cover this issue in more depth in my
latest book, Tips for Successfully Managing Your 401(k), which will be available
for sale later this year. I will be writing an article on this subject that will appear on
this Web site in November.
Q: Currently, I make a full contribution of 15 percent
of salary to my 401(k) plan, but I have some bills coming due. My 401(k) account has lost
over 12 percent thus far this year. Would it be wise to reduce my contributions for a
while (while putting in enough to get the company's matching contribution of 3 percent) in
order to have some "extra" cash, to deflect some of the brunt of these bills? I
realize that I'll be taxed on this money.
TB: The fact that your investments aren't doing very
well at this time should not cause you to decrease your contributions. You should keep
your contributions at the same level unless you can't afford to do so. Continuing to
invest during periods when fund values and stocks are down is one of the smartest things
you can do. Your investment results will be better if you buy as many shares as possible
now, rather than later when prices are higher.
Drop your contributions to a lower level only if you have
to do so to pay your bills. Once you pay off your bills, don't forget to increase your
401(k) contributions again.
Ted Benna, creator of the first 401(k) retirement savings
plan, will answer your most intriguing questions every Tuesday. With over 30 years of
experience as an employee benefits consultant, Ted is a nationally recognized expert on
benefits issues. He has authored two books, Helping Employees Achieve Retirement Income
Security and Escaping the Coming Retirement Crisis, and is President of the
401(k) Association. Ted is a frequent speaker at meetings of 401(k) plan sponsors and
participants. His articles and comments have appeared in numerous publications, including The
New York Times and The Wall Street Journal.
 Read Ted Benna's Biography
Ted's Table Archives
The information provided here is intended to help you understand the general issue and
does not constitute any tax, investment or legal advice. Consult your financial, tax or
legal advisor regarding your own unique situation and your company's benefits
representative for rules specific to your plan.
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