What are the things you need to know before taking out a 401(k) loan?

Q. I am currently in a tight financial situation. The company I have worked in for over ten years offers a 401(k) plan to its employees. I was thinking of taking out some amount from my 401(k) account as a loan. However, I have heard that this may not always be the best option. I wanted to know more about how a 401(k) loan works, and any other thing that will be of help. Scott, Wisconsin

Hi Scott, while you may be tempted to take out a 401(k) loan, it is true that it may not always be the best option since failure to repay will have serious consequences. Consider it your last resort if you have no other options. Many people think that since you are borrowing your own money, it is a simple process. But the truth is that taking out a 401(k) loan is not as simple as it sounds.

If you still think that borrowing from your 401(k) plan is the way to go, then there are some things to keep in mind. The first thing you have to check is how much you can borrow. Usually, the limit is set to 50 percent of your retirement plan or $50,000 – whichever is the lesser amount.

When borrowing from your 401(k) plan, you don’t have to go through a credit check since you are taking out your own money; no financial institution is loaning you the money.

However, even though you do not have to run a credit check, you still have to pay the interest. The interest rate depends upon your loan plan, which is usually based on the current industry rates. Apart from this, taking out a 401(k) loan will also require you to follow a strict repayment schedule. This means that you have to pay back your loan, along with interest, within five years. However, if you use the loan to buy a home, the period for repayment is usually more than ten years.

Lastly, make sure that you do not miss any of your payments. Failure to repay your 401(k) loan on time will have some serious repercussions. If you miss a payment, your employer will regard it as you withdrawing from your 401(k) plan. This means that not only will you have to pay taxes on the loan you take out but also pay the penalty for withdrawing from your retirement plan early.

Why is 401K Called a Defined Contribution Plan?

Is the 401k plan a ‘defined contribution’ plan? Does this mean I have to specify the contribution I make to the plan for my employees when I set up the plan?- Joyce Gallagher, Florida, runs a cake shop with 10 employees

The 401k plan is a defined contribution plan just like IRAs, Simple IRAs and SEPs. The amount that you contribute to this plan is defined either by you, the employer, or the employee or participant. This is why this retirement plan is termed a defined contribution plan.

But this does not mean that when you set up a 401K plan for your small business you are forced to make contributions to it irrespective of whether your business can afford it or not. There are many ways in which you can define your contribution. You can go for a profit sharing contribution which links your cake shop’s performance to your contributions. You can commit to a specific percentage match of your employee’s contribution as a means of encouraging participation. You can even entirely avoid outlining about your contributions in your 401K plan document at the time of set up if you want to have maximum freedom. When you do this, employer contributions, that is, contributions from your side become entirely discretionary.

It does make good business sense to stick to a regular employer contribution schedule though. Remember that you can claim deductions over your contributions and also get tax credits for funds going into this retirement plan.

If you have an existing plan but want to transform it into a more flexible one, you can find some excellent tools to do this quickly and painlessly at http://401k-network.com. This site has a comprehensive listing of the various online tools that can make setting up, managing and administering your 401k a breeze.

Catch up Contributions

Tell me more about Catch up Contributions with 401k plans. Who can make them and why is it important to know about these contributions?- Wallace M. Linn, Wichita, KS 67202

Catch up contributions allow employees to make up for a late start in saving for their retirement. If an employee is nearing his retirement age and has very little set aside to live on once he crosses this age, it is very important for him to maximize the savings he can put aside right away. Catch up contributions actually give him a second shot at making retired life financially secure. That is why it is important for your employees, especially those who are older, to know about these contributions.

The IRS regulations say that employees who have crossed the age of 50 can make catch up contributions to their 401k account. In effect, these employees can make their regular contributions and also add in an extra bit to make up for lost years. Different kinds of 401ks allow different catch up contributions which is why it makes things much easier for you, the employer, to sign up for a DIY 401 suite like http://401k-easy.com/. These packages are constantly updated with the most recent IRS limitations and rules. You can always be sure of staying within the law when you administer the plan using this software. Remember that during times of inflation, the IRS usually allows bigger catch up contributions and vice versa so the rules are prone to fairly frequent changes.

If you do intend for your older employees to be able to save more for their retired life, make sure that you add the provision for catch up contributions to your plan right at the outset. Although the law does not make it mandatory for you to include this provision, adding it to your plan is a good way to keep your employees happy. Do remember that without this provision in your plan document, you cannot allow catch up contributions to the plan.

401k Catch Up Contributions

What are catch- up contributions to a 401k? Can my employees make such contributions to the small business 401k I offer? Katie D. Harris, Beaverton, OR 97005, manages a home furnishing outfit.

Catch up contributions are a means by which you or your employees can make up for starting your retirement planning late in life. Those people who failed to set aside some portion of their earnings through the early years of their career get a second chance for future financial security through catch up contributions. Employees above the age of 50 can make their catch up contributions into their 401k account. TheIRSallows them to make an ‘extra’ contribution over and above the maximum allowed by law for other participants.

What you should know as employer is that the ‘extra’ allowed by theIRSis dependent on the plan’s features and conditions. For example, a Simple 401k allows a much smaller ‘extra’ contribution than a traditional one does. Also, theIRS’s allowance for the extra contribution depends on whether or not your plan assumes additional contribution limits from your employees.

TheIRSmay change its own allowance for the extra contribution subject to fluctuations in the inflation index. If inflation rates are going through the roof then above 50 participants may be allowed to contribute a bigger sum in addition to the regular contributions.

One critical aspect for you to remember is that your employees can make catch up contributions to their account only if you have made provisions for this in your plan. The law does not require you to allow such contributions. This is a provision you make at your discretion if many of your employees request you to do so.

Adding this provision can show your employees that you prioritize their best interests. This will lead to better loyalty and improved employee morale in your business. Use a DIY package like http://401k-easy-online.com/ to make keeping track of various employee contributions easy. This package will help you manage the 401k funds and keep records updated with just a few minutes of work each month.