The 401(k) plan is a type of retirement plan that meets the requirements of Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act of 1974 (ERISA). Hence, it is a tax qualified plan and is eligible for favorable tax treatment. It is also a deferred compensation plan, which is the same as saying that a portion of the employee's salary is not paid until retirement, to ensure that it falls in the lower income tax bracket. Thus, a 401(k) plan is a qualified deferred compensation plan, that is established by employers on behalf of eligible employees, who elect to have the former contribute a limited amount of their wages on a pretax basis.
The employers can make matching or non-elective contributions to the 401(k) plan on behalf of employees, and may choose to add a profit-sharing feature to the plan. Since this is a qualified plan, the employers are allowed to deduct their contribution for each participant before calculating taxes. Contributions and earnings accrue on a tax-deferred basis until they are withdrawn.
Distribution of elective deferrals before the age of 59½ will result in the borrower incurring a penalty of 10 percent additional tax, unless the employee dies, becomes disabled, or faces hardships. Early distributions are also allowed if the plan is terminated.
Understanding the Concept of Loan Against 401(k) Plan
The plan document will specify if one is permitted to borrow against 401(k). Most plans allow the borrower to avail a loan that is equal to 50 percent of the vested account balance. The maximum amount of loan that can be procured cannot exceed USD 50,000. Moreover, it has to be repaid within a period of 5 years, unless the loan was for the sake of buying the borrower's primary residence, in which case, the repayment period is usually 10 to 30 years.
For Down Payment on a House
People who need money for making a down payment on a house may consider borrowing against 401(k), for home purchases qualify for a repayment period of 10 to 30 years. The repayment of the loan is a fairly simple procedure since the amount is deducted by the company from the employee's paycheck. In fact, it is akin to borrowing from oneself at a low rate of interest without any credit checks. The interest is usually a few points above the prime lending rate.
Although a loan against 401(k) seems ideal, there are a few drawbacks. People end up losing interest on the amount that is borrowed, since the borrowed sum does not appreciate on account of capital gains, interest, and dividend income. The money that is borrowed is repaid with after-tax dollars. Hence, one is unable to benefit from the tax-sheltered component of the plan. The loan may become a premature distribution if the employee is unable to repay the borrowed sum. Hence, borrowing against 401(k), for a house, should be considered only if one has exhausted all other avenues of procuring loans.
People who need to purchase a home, but do not have the necessary finances, may be able to buy a home by monetizing the USD 8000 tax credit that is being provided to first time home buyers.