Should You Borrow From Your Retirement Plan?

A 2014 study showed that one third of Americans have taken a loan from their retirement savings plan, and 43% of them have taken two or more loans. But can, and should, you borrow from your retirement plans? Kyle Jones, Financial Planner at Wamhoff Financial Planning and Accounting Services, review the options, pros and cons.

  • Can you borrow against your retirement savings plan?
    • According to the IRS, “retirement plans may offer loans to participants, but a plan sponsor is not required to include loan revisions in its plan.”
    • IRA’s and IRA-based retirement plans such as SEP, SIMPLE IRA, or a SAR-SEP plan cannot offer participant loans.
    • Loans from an IRA or IRA-based plan would result in a prohibited transaction.
  • If it’s determined that you can borrow from your plan, what should you consider before doing so?
    • According to the IRS, the maximum amount you may borrow is 50% of the vested account balance or $50,000, whichever is less.
    • Your loan typically must be repaid in full within five years, and payments must be made at least quarterly. An extension of the five years is permissible if your loan is being used to purchase a primary residence.
    • Loan payments are made through automatic payroll deductions using after-tax money. This reduces net household cash flow and loan payments are not tax deductible.
  • What consequences, or pitfalls might you face?
    • If a loan payment is not made within every 90 days, the loan amount will be considered a distribution and taxed as ordinary income.
    • If you are under age 59-1/2, a 10% penalty in addition to the taxes would be applied.
    • If you leave your current job (or are terminated), you must repay the entire loan or incur the same penalties that apply for early distribution.
    • The loan balance is not invested back into your portfolio until the entire principal is paid back, so you lose investment opportunity with this money.
  • The bottom line:
    • Most financial advisors will recommend that borrowing from your company’s retirement plan should be the last place you look to borrow funds. Primary reason is the potential tax implications that result if a job is lost or payments aren’t made in a timely fashion.
    • If you need additional funds, a Home Equity Line of Credit is a more tax efficient way to take out a loan.
    • Ultimately, borrowing from your retirement plan breaks the golden rule of personal investing which is: Always Pay Yourself First.

Sources:
https://www.tiaa-cref.org/public/pdf/C17502-Borrowing-Survey-Executive-Summary.pdf
http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-Loans
http://www.investopedia.com/articles/retirement/05/retirementloan.asp
http://www.forbes.com/sites/learnvest/2014/03/28/the-skinny-on-borrowing-money-from-your-401k/2/
http://www.investopedia.com/articles/retirement/06/eightreasons401k.asp