I want to cover the topic of borrowing from your retirement savings while still in the pre-retirement accumulation phase of your life. This method of liquidity is often shamed in my industry, but it can provide much needed cash in times of need or opportunity. With that said it is very important to understand this concept in great detail, to avoid some of the very painful outcomes that can come up from a lack of understanding.
The Basics of Taking a Loan From Your Retirement Account:
A loan from your employer sponsored plan (401k, 403b, 457, profit sharing, etc.) is an option available in most plans. However, it is possible that your employer has removed this option from the plan making it unavailable. Here are a couple of details.
- A plan participant can take a tax-free loan* in an amount of 50% of the plan balance or $50,000, whichever is less.
- The loan is typically paid back in a term no greater than 5 years. Typically, you can pay the loan back sooner than that without a pre-payment penalty.
- Interest charged on the loan is based on the “Prime Rate” (which is the rate banks will charge to their best customers) plus 1%-2%. At time of this writing the Prime rate is at 5.25%.
- The interest payable is paid back into your retirement account. Therefore, payable back to you rather than a financial institution like a credit card company or a bank.
* Please read the Bad of Borrowing paragraph below.
The Bad of Borrowing From Your Retirement:
I will cover some of the often-overlooked benefits of this option below, but you need to understand some of the potential issues a 401k loan can create.
- In the event of any severance of employment (termination, retirement, other reasons) the balance of the 401k loan will be payable in a relatively short window of time (typically 60-90 days). If the balance of the loan cannot be paid back during that period, the balance will be considered a taxable distribution from your retirement plan. You may also be subject to early withdrawal penalties if you are younger than 59 ½.
- Since you are removing assets from your 401k investment options, it is possible the rate of return on those assets will decrease while you pay the loan back. For example, if the mutual fund that the funds originally were in earned 8% during payback term of the loan and the interest you paid yourself was 6.25% you would miss out on 1.75% of return.
- If the repayment of the loan causes you to stop making contributions into your 401k plan it can have a negative long-term affect to your retirement plan.
The Good of Borrowing From Your Retirement:
Below are a few of benefits of this option.
- You receive the cash from your plan with relative ease. Since this is not a loan that requires a credit check (the funds are yours, not a bank’s) the application process can be quicker and any potential credit issues you have shouldn’t impact the ability to access your funds. Also, you should pay minimal loan origination or application fees, if any, to get the loan established.
- You are paying yourself back rather than paying interest to a bank or credit card company. As mentioned above, the loan interest is paid back into your retirement account.
- The interest rate is often very competitive compared to other short-term options. If you compare the current rate of 6.25% versus that of a credit card, which is often above 10%, you can see the advantage.
- The repayment terms are relatively flexible, with a maximum 5-year payback to spread the repayment out; or if you would like you can typically repay the loan early without penalty.
Two Examples of Borrowing from Your Retirement Account:
Every year I work closely with my clients to find methods to pay for all the opportunities and challenges that life can bring. Often taking a loan from their retirement plan makes that short list of viable options to meet the obligation. Here are a couple examples where the 401k loan has been the best option.
- Highly appreciated stock: The client had the option of selling stock they owned outside of a retirement account. This is often a great resource for clients but in this case the capital gain from the sale of stock would have caused the client to move into a higher tax bracket, causing them to pay thousands of dollars in tax to the IRS rather than loan interest to themselves. Because of the flexible repayment terms, we were able to sell some stock each of the next couple of years to pay the loan off while keeping the client in the lower tax bracket.
- Selling high growth assets: Similar to the example above this client has stock in a non-retirement portfolio but in this case the issue was not taxation, but rather opportunity cost. This client believed the stock they owned had high growth potential, especially when compared to the interest rate they would be charged for the 401k loan. This is a scenario without a clear outcome, since the stock the client owned had no guarantee of success. There was no way to know if taking the loan would be more advantageous than selling the stock, but the client was willing to take the risk. In this scenario, the client had to feel confident that they could repay the loan without selling the stock, since the stock growth was speculative and may not have created the growth needed to payback the loan.
Final Thoughts on Borrowing from Your Retirement Account:
This concept like any should be discussed with your trusted financial resource. A retirement plan loan can be a great solution to a cash need but must be completely understood to avoid the potential for a negative outcome.
In the beginning of this article, I linked to one of many articles saying why this is a bad idea. Below are some articles that agree with me.
- First up is an article that lays out some of the positives, and some details about how it works. Interestingly, it’s from the same source as the “don’t” article I linked above.
- Next is an article that talks a bit how the interest is calculated, and lays out some times that borrowing can make sense.
- Last up is a calculator to help you understand a bit about how your particular numbers work out.
Borrowing money from your retirement is a complicated decision. If you have a financial adviser, this is a good time for them to help you out. If you don’t have one, check to see if your ongoing, or severance, benefits include financial advice. Either way, I hope you find this article helpful.
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