The purpose of a retirement plan is to finance your post-work years, allowing you to maintain or improve upon your pre-retirement standard of living. As such, your financial/retirement planner will encourage you to save as much as you can in your retirement account and to defer making withdrawals for as long as is permitted under the plan. Taking a loan from your retirement account may adversely affect your retirement savings, but there are instances when taking such a loan makes sense. In this article, we look at some of the pros and cons of taking a loan from your retirement account.
Taking a Loan vs. Making a Withdrawal
If you do take a loan from your retirement plan you are, in fact, removing a portion of your balance. For instance, if your balance is $100,000 and you borrow $40,000, you will have a balance of $60,000. However, taking a loan is different from making a withdrawal. A withdrawal reduces the assets in your portfolio and you are not required to return the amount withdrawn to the plan, whereas a loan is treated as part of your portfolio and must be repaid to the plan in order to avoid tax consequences. (See Sometimes It Pays to Borrow from Your 401(k).)
Diversification is an important part of retirement planning. (Read: The Importance of Diversification.) Retirement planners usually recommend that assets be diversified according to the risk tolerance of the individual client. While planning is based on the past and projected performance of assets, the risk must be considered, except when it comes to assets that produce a guaranteed rate of return or guaranteed interest. One of the drawbacks of borrowing from your retirement plan is that the loan amount is no longer being invested in the portfolio of assets in your retirement account and, therefore, the opportunity for diversification using that amount is lost until the amount is returned to the plan.
However, when you take a loan, the loan amount will be treated as an asset in the plan, as it will be replaced by your promissory note. While the amount will not be diversified, it will receive a guaranteed rate of return, which could be an average of prime rate plus 2%. Remember that diversification comes with risks, and the possibility exists that you could have a negative return on your investments unless some of your investments have a guaranteed rate of return. Therefore, the advantage of taking a loan from your account is that you will receive a guaranteed rate of return on the loan amount.
One of the arguments against taking a loan from your retirement plan is that the amount you repay in interest will be double taxed. This is because the loan repayments, including the interest, will be repaid with amounts that have already been taxed and will be taxed when withdrawn from the retirement account.
“As soon as your after-tax loan repayments hit your 401(k) plan they become pretax, and when you retire and start taking distributions, your loan repayments will be taxed again,” says Michael Mezheritskiy, president, Milestone Asset Management Group, Avon, Ct. “Hence, double taxation.”
Let's look at an example:
Assumption No. 1:
The $110,000 will be taxed at your ordinary income tax rate when withdrawn from your retirement account. Because the $100,000 came from pretax monies, and the earnings of $10,000 accrued on a pretax basis, the $110,000 will be taxed only when withdrawn.
Assumption No. 2:
The $110,000 will be taxed at your ordinary income tax rate when withdrawn from your retirement account. Since the $100,000 came from pretax monies, and the $8,500 earnings accrued on a pretax basis, the $108,500 will be taxed only when withdrawn. However, the $1,500 that came from interest repayment on the loan was repaid with amounts that were already taxed, and it will be taxed again when withdrawn from your retirement account. As a result, you will be paying taxes twice on the $1,500.
Consequences of Failing to Make Repayments
With a few narrowly defined exceptions, loans taken from your retirement account must be repaid at least quarterly, and they must be repaid in level, amortized amounts of principal and interest. Failure to meet these requirements could result in the loan being deemed a taxable transaction. It would also mean that you lose the opportunity to accrue tax-deferred earnings on the amount and to make diversified investments with it.
“I think it is always best not to borrow from a retirement plan unless it is a last resort. Even though doing so is positioned as a tax-free way to access the capital, it doesn’t always work out that way,” says Allan Katz, president of Comprehensive Wealth Management Group, LLC, in Staten Island, N.Y.
If you leave your employer before the loan is repaid, you may be required to repay the entire balance within a short period, instead of over the established schedule. If you are unable to repay the balance, the plan may treat it as a distribution (offset). The loan, therefore, would be treated as ordinary income unless you have available funds to replace the amount as a rollover contribution to an eligible retirement plan within 60 days after the date the offset occurs, or you are eligible to complete a direct rollover of the promissory note to another qualified plan.
Loan balances that are treated as distributions are not only subject to income tax, but also may be subject to the 10% early-distribution penalty.
Why Take a Loan from Your Retirement Plan?
You should take loans from your retirement plan only if you have exhausted your other financing options, or if the loan will help to improve your finances. For instance, if you had credit card balances of $20,000 with an interest rate of 15% and you could afford to pay $400 per month, it might make good financial sense to take a loan from your retirement plan in order to pay off your credit card balances. Let's compare the two scenarios:
|Retirement Plan Loan Amount||$20,000||Credit Card Balance||$20,000|
|Interest Rate||4.50%||Interest Rate||15%|
|Payment Frequency||Biweekly||Payment Frequency||Monthly|
|Payment Amount||$171.94||Payment Amount||$400|
|Repayment Period||Five years||Repayment Period (if repayment is $400/month)||Six years and 7 months|
|Total Interest||$2,351.41||Total Interest||$11,582|
While it is true that the $2,351.41 you pay in interest on your loan amount will be double taxed, the obvious benefit is that the interest will be repaid to you, instead of to a credit card company, and the amount you pay in interest will be significantly lower.
If you do take a loan from your retirement account to pay off your credit card balance, make sure you take steps to avoid accruing indebtedness under the credit cards. Check with your financial planner for assistance in this area – he or she can also help you ensure that your credit score is not adversely affected.
Another good reason for taking a loan from your retirement account is to use the loan amount to purchase a home. As industry trends show, amounts invested in your home provide a significant return on investment. Furthermore, you could also use your home to finance your retirement, whether by selling the home or by taking a reverse mortgage.
“I recommend borrowing from the retirement plan for capital expenditures such as home repairs or to start a business, and for debt consolidation in certain situations,” says Wes Shannon, CFP®, founder of SJK Financial Planning, LLC, in Hurst, Texas. “Never borrow from a retirement plan for education expenses. The government makes easy low-cost loans available for college, but not for your retirement.”
Check Your Plan Provisions
Not all qualified plans allow loans, and some that do will only allow them for special purposes such as purchasing, building or rebuilding a primary residence, or paying for higher education or medical expenses. Others allow loans for any reason. Your plan administrator will be able to explain the loan provisions under your retirement account.
Replenish Your Account After You Take a Loan
If you must take a loan from your retirement account, try to continue making contributions and increase the amounts you contribute, where possible. This may be a challenge, as you will also be required to make loan repayments, and those repayments will not be considered contributions to your retirement account. However, it will help you restore your nest egg much faster.
Most plans will allow you to accelerate your loan repayments, which will help to restore your plan balance more quickly. Be sure to factor your loan repayment into your budget. This will keep you from overspending.
The Bottom Line
You should not take a loan from your retirement account unless it is an absolute necessity or it makes good financial sense. Determining whether a loan is right for you requires an assessment of your financial profile and a comparison of the loan option with other options, such as taking a loan from a financial institution (if available) or paying off credit card balances over time. Be sure to discuss the matter with your financial planner, so that he or she can help you decide which option is best for you. (Also read: Understanding Credit Card Interest.)