Of course, that rate of interest is typically lower than the participant could earn in the retirement plan—and it has to be paid on an after-tax basis, to boot.
In 2008 I wrote a piece for the “Know How” section of PLANSPONSOR magazine to introduce the concept of the trade-offs a participant should consider in taking a loan—hence, the notion of “borrowing from Peter to pay Paul.”
Most participant-directed retirement programs today offer participants the ability to borrow against their accumulated savings for a variety of reasons, both significant and mundane. It has long—and perhaps rightly—been viewed as an important incentive in encouraging workers to participate in the program.
Still, taking money from the plan, however temporarily, runs counter to the basic premise of tax-deferred savings. Every day the money is not in the plan, the participant loses ground in saving for retirement. On the pages that follow are my attempt to outline the considerations in a manner directed TO participants.
I hope it helps you – and your participants – make a choice that represents a good balance of their current need for cash with their need for cash in the future.
Would love to hear any/all feedback at email@example.com.
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 things—the kids need braces, your car breaks down, the house needs a new roof—or maybe your variable rate mortgage has proven to be more “variable” than you thought.
When you’re 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 aren’t 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 bank’s “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.
It’s easier than getting a loan form the bank.
It’s cheaper than running up your credit cards.
Repayment is generally via convenient payroll deduction.
You are, effectively, paying yourself back, with interest.
So, what’s 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 - and you won't have that $14,600 at the end - you will only have $11,500.
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. That’s because, while you have effectively borrowed money from yourself, you actually borrowed money from the plan – and that has to be paid back. You can’t just decide to let things slide.
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
While it may seem like a good idea to borrow from your 401(k), 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 pocket—money that you have paid taxes on—and 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 immediately—or have it netted against your current retirement plan balance—and in either case will have a tax bill to settle with the IRS