RETIREMENT ACCOUNT LOANS--Should you use them?

The list is long--kids in college, a move to a newer house or a remodel of the current one, family members to support, and vacations to be taken before you're too old, etc. How is it possible to meet all expenditures on both the needs and wants lists?  You might be considering a loan against your retirement funds because, "hey, the money is mine, right?"  Slow down and consider the following before you follow through with a retirement account loan.

Plan sponsors determine the specific rules for qualified retirement account loans; however, these are some general rules that usually apply:

  • You can borrow up to 50% of your plan's vested balance, usually capped at $50,000.
  • Interest rates on the loan are generally lower than those found with credit card advances or unsecured loans.
  • Interest rates are not dependent upon your credit score, since they are set by the plan document not by the applicant's credit worthiness.
  • The loan application process is relatively easy and quick, as compared to loans obtained through commercial lenders.

But, as with most things, there are some drawbacks that should be considered:

  • The amount you withdraw isn't available to be invested, which prevents it from earning the deferred-tax benefits for which you invest in a retirement plan to achieve.  This is otherwise known as "opportunity cost" or the intrinsic cost of making one financial decision as opposed to another (i.e., loss of growth potential in your retirement account because of a loan being taken).
  • If you separate from your employer for any reason (e.g., layoff, retirement, termination, etc.), the loan is generally immediately due and payable.  This might make an already stressful time much worse, as you've added a loan repayment at a time when you may be experiencing the tightest funds.
  • If you don't repay the loan, it's considered a distribution, which would make it taxable income, along with a potential 10% early withdrawal penalty if you are younger than age 59 1/2.  Under these circumstances, any benefit gained from a lower-than-market interest rate could simply disappear.
  • Interest payments on loans made from 401(k) and 403(b) accounts are generally not tax-deductible, no matter how you use the loan proceeds.  Only loans from non-elective employer contributions, as seen in most pension plans, where the proceeds can be traced for use in purchasing a qualified residence, education costs, business or investment purposes may allow the interest payments to be tax- deductible.  However, that's only if you are not a "key employee."  Simply put, the hurdle is high for tax deductibility.
  • Interest payments, which, as discussed above, are usually made with after-tax funds, are taxed twice.  The first tax occurs because you don't derive a tax deduction for those funds that pay the interest portion of the loan.  The second tax occurs when you make a withdrawal from your account in retirement, of which the repaid interest is a part.  That withdrawal is taxed, which is the usual course for a qualified retirement plan.

Given the long list of drawbacks, you should probably take a long look at the purpose for which you are considering a retirement account loan.  If it's for a "want" and not a "need," the wisest course might be to decide it's not worth the price and simply do without or put off the expenditure.  If the purpose passes that test, then other borrowing options should be examined.  Hopefully, you'll find options that come with lower risks than those discussed within this article.

Focus on the fact that the account was established to fund your retirement years.  With average life expectancy increasing, hopefully your retirement years will be many, and no one wants to run out of money!

Please contact us if you have questions about what to consider before following through with a retirement account loan.

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Material discussed is meant for informational purposes only, and it is not to be construed as investment, tax, or legal advice. Please note that individual situations can vary. Therefore, this information should be relied upon when coordinated with individual professional advice.

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