KnowHow Archive

Plan Sponsor Guide Participant Guide

Robbing Peter to pay Paul

Borrowing money from yourself isn’t always a smart bet

Things are going along just fine. You've been paying your bills, putting food on the table, setting aside money for retirement. Then, seemingly out of nowhere, here comes an emergency expense.

It could be any number of thingsthe kids need braces, your car breaks down, the house needs a new roofor maybe that tax refund wasnt quite as big as youd hoped.

When youre a bit strapped for cash, it may be tempting to think about dipping into your retirement account. Taxes and penalties generally discourage people from taking an outright withdrawal, but a growing number of retirement programs offer temporary access to those funds through what is called a participant loan.

However, before you take such a "dip," you might want to consider the potential cost.

How it works

If your plan has a loan option (they arent required to), you generally can borrow from your retirement account, subject to the following limitations:

How much: Up to half your vested account balance or $50,000, whichever is less.

How long: For anything other than the house you live in, the loan must be paid back in five years (loans for your principal residence still have to be repaid within 15 years)

Interest rate: It depends, but your local banks prime rate plus 1% is typical

Your program also may impose a minimum amount for the loan ($1,000 is typical), as well as charges for processing your loan request.

The advantages
Its easier than getting a loan from the bank.
Its cheaper than running up your credit cards.
Repayment is generally via convenient payroll deduction.
You are, essentially, paying yourself back, with interest.

So, whats the catch?
Simply stated, you may be taking money away from your best investment option-dramatically slowing your rate of retirement savings-and replacing it with money that is more expensive than you may think. 

Let's assume the following. You want to borrow $10,000. You will pay it back over 5 years, and you will pay that money back at a 5.75% interest rate.

If you left that $10,000 in your retirement plan - and it earned 8% during that period, it would be worth more than $14,600 at the end of the five years.

In order to pay back that $10,000, plus interest, you will have to come up with more than $11,500 over the next five years.

One more thing
Worse, over a 20-year time periodthat extra $4,600 in earnings could add up to ANOTHER $12,000.

Changing jobs
If you change jobs, the note on your outstanding loan generally will have to be paid off immediately. That means you will have to either come up with the money, or have the outstanding balance taken from your existing retirement plan balance.

Unfortunately, once that loan is charged off against your account, you will have to pay taxes on the amount, which the Internal Revenue Service now considers to be a taxable distribution.

The bottom line
Sometimes you need money you dont have to take care of business. Certainly, your retirement account can help out in an emergency, but every day that money is not in your retirement account costs you. And time is your best friend when it comes to saving for retirement.

While it may seem like a good idea to borrow from yourself, remember:

The money you take from your retirement account is not earning tax-sheltered returns, so it will take you longer to achieve your retirement savings goals,

You repay the loan with money from your own pocketmoney that you have paid taxes onand will pay taxes on AGAIN when you actually withdraw the money at retirement.

If you change jobs, you will probably have to pay back the remaining amount of the loan immediatelyor have it netted against your current retirement plan balanceand in either case will have a tax bill to settle with the IRS

Bear in mind that, just because you are borrowing from yourself, doesnt mean there isnt a cost.