The risks in borrowing from your retirement plan

By MassMutual Staff

By MassMutual Staff

Posted on Sep 4, 2020

If you need funds for an emergency or other urgent reason, borrowing from your retirement plan may be an option.

Most qualified retirement plans — 401(k) plans as well as 403(b) and 457(b) plans for workers in the nonprofit and public sectors — offer some type of loan on terms specific to the particular plan. And, unlike commercial loans, retirement plan loans do not require a credit check, so they are available even to those with unfavorable credit scores. Also in paying back the loan, you are essentially paying back yourself.

But financial professionals generally advise against tapping retirement funds, except as a last resort. Those funds, after all, are meant for your retirement when you likely can’t work anymore. And borrowing the funds diminishes the ability for compounding savings gains. Also, because you are contributing pretax dollars to retirement plan, but repay that loan with after-tax dollars and also pay taxes when you start to take distributions from the plan, you essentially pay taxes twice on the loan amount. Also, many plans charge a fee to take out the loan and a fee to maintain the loan.

Nevertheless, people do borrow from their retirement savings for a variety of reasons.

Does your retirement plan offer loans?

Employers that sponsor retirement plans are not required to allow for loans, but many do. Retirement plan participants can read their summary plan description (SPD) to find out if they are eligible to take loans from their plan. If so, the SPD will state the company’s loan terms, which must fall within IRS guidelines. Employees can also check with their human resources department.

The IRS limits how much workers may borrow from their retirement plans. In the past, employer plan sponsors have not been permitted to allow plan participants to borrow more than:

1) The greater of $10,000 or 50 percent of their vested account balance; or

2) $50,000, whichever is less.

In other words, if your vested retirement plan balance was $60,000, you were only able to potentially borrow up to $30,000. If your vested balance was $120,000, you may have been able to borrow up to $50,000.

But the CARES Act stimulus bill, passed by Congress in March 2020 to help both working Americans and employers withstand the financial toll wrought by the coronavirus pandemic, relaxed many of the rules related to both retirement plan loans and outright withdrawals. For participants in eligible retirement plans, the legislation raises the limit on loans to the lesser of the vested plan balance or $100,000. To qualify, the loan must be made by September 22, 2020, and the participant will not owe income tax on the amount borrowed from the 401(k) if it is repaid within five years, according to the IRS.

Generally, the IRS requires retirement plan borrowers to make substantially equal loan repayments at least once per quarter, and those payments must include both principal and interest. You cannot take more than five years to repay the loan, unless the loan is specifically for the purchase of a primary residence, which allows for a longer payback period.

The IRS does not permit loans from individual retirement accounts (IRA)s. Any distribution from a traditional IRA before age 59-1/2 is subject to ordinary income taxes, plus a 10 percent early withdrawal penalty. (The CARES Act does allow for penalty-free distributions from qualified retirement plans, including IRAs, of up to $100,000 for 2020 for those experiencing hardship as a result of the coronavirus pandemic.)

Use retirement plan loans with caution

Many plans require loan repayment through payroll deductions. But many who take a retirement plan loan decrease their contribution amounts to the plan during the time of repayment. That makes it harder to reach their retirement goals.

Failing to contribute to your retirement plan for any period of time is a missed opportunity to build savings. And if your company matches a percentage of retirement contributions, as many do, you’ve left money on the table. So if at all possible, and if your plan allows it, keep making contributions to your retirement savings account at the same rate while you’re repaying your loan.

And make sure to repay your loan. Why? Failure to repay your loan balance on time will be considered a distribution and you will owe taxes (at your marginal income tax rate) and a 10 percent early withdrawal penalty if you are younger than age 59-1/2 on the amount you have not paid back.

While you’ll have to pay taxes on any retirement plan withdrawal eventually — even if you wait until retirement age — the penalties are a waste. Further, never paying yourself back could significantly hurt your long-term net worth. The money you take out won’t be earning investment returns and compounding. Agreeing to repay your loan through automatic payroll deductions can help keep you honest.

Generally speaking, financial professionals suggest retirement savers avoid taking out a qualified plan loan if a layoff, job change, or company acquisition seems imminent, because any of these events could mean that you would have to repay your loan in full within a certain time period — an obligation you might not be in a position to fulfill, turning the unpaid loan balance into a taxable distribution.

Another potential problem with retirement plan borrowing arises if you must sell investments at a loss to borrow money. It is one thing to lose money on paper when the stock market is down; it’s another to make those losses real by selling your investments.

If you have an urgent need and have no way to cut your expenses, a retirement plan loan might make sense. Further, if you have bad credit and can’t get a commercial loan at a low interest rate, a retirement plan loan may be your best option.

But the math has to make sense for your individual situation. If you’d lose 6 percent per year in investment earnings by borrowing from your retirement plan, but you’d avoid paying 20 percent interest on a personal loan or credit card balance, the retirement plan loan will be less expensive.

Hardship withdrawals

Those experiencing a true financial crisis may also be eligible for a hardship withdrawal from their 401(k), 403(b), or 457(b) plan.

And, in 2020, retirement plan participants may also be eligible to withdraw up to $100,000 from their qualified retirement account and, if they are younger than age 59-1/2,  without incurring the standard 10 percent early distribution penalty. The distributions can be included in the employee’s income tax over three years and are not subject to a mandatory 20 percent federal withholding for “eligible rollover distributions,” as defined by the IRS.

To qualify for the penalty-free distribution under the CARES Act, however, participants must have experienced adverse financial consequences resulting from a reduction in work hours; have been laid off, quarantined, or furloughed; have a spouse or dependent who has been diagnosed with coronavirus; or have been unable to work due to a lack of child care because of the virus. (Related: What the stimulus package, CARES, does for you)

As the CARES Act currently stands, such leniency for retirement plan withdrawals is only available for 2020. After that, the traditional rules that have long governed hardship withdrawals are likely to resume.

As with loans, your plan sponsor is not required to offer hardship withdrawals, and it is up to them to determine which conditions apply.

Under IRS guidelines, the employee, the employee’s spouse, or the employee’s dependent must have an “immediate and heavy financial need” and the amount withdrawn must be “necessary to satisfy the financial need.”

Acceptable reasons to take a hardship withdrawal may include paying medical expenses, buying a primary residence, paying tuition and fees, avoiding eviction or foreclosure from a primary residence, paying for burial or funeral expenses, or repairing damage to a primary residence. (Related: Handling a financial disaster)

You cannot take a hardship withdrawal from retirement savings if you have other resources to meet your need, according to the IRS.

For example, someone who owns a vacation home, but is having trouble making payments on their primary residence, would probably be expected under the terms for most retirement plans to sell the vacation home to meet cash flow problems rather than take a hardship withdrawal.

Most retirement plans also provide that hardship withdrawals are not available if you could obtain a commercial loan to solve your problem or if you have not exhausted your options for taking out a loan from your plan.

If you take a hardship withdrawal, you will not be allowed to contribute to your plan again for at least six months. The distribution from the retirement savings plan will be taxed as income and assessed a 10 percent penalty unless you are at least 59-1/2 years old. (Again, unless your withdrawal qualifies for the penalty waiver for 2020, under the CARES Act.)

Unlike a retirement plan loan, a hardship withdrawal does not have to be repaid — in fact, you cannot repay it even if you want to. However, the CARES Act permits coronavirus-related hardship withdrawals to be repaid into an IRA or qualifying retirement plan within three years to avoid taxation. Any taxes already paid, because the withdrawal is taxable over three years, may be refunded to the extent the amount taxed in prior years was repaid. An amended tax return may be required.

At most, you could try to make up for the withdrawal by increasing your retirement plan contributions for retirement later on when your financial situation improves.

For example, if you were contributing 5 percent of your pretax earnings to your retirement plan before you took the hardship withdrawal, once you’re allowed to contribute to your plan again and have the resources to do so, you could increase your contribution rate to 10 percent or more.

Retirement plans should not be used as a piggy bank. But for those experiencing a financial emergency, a loan or withdrawal from retirement plan savings does not necessarily doom their financial future, either.

Just be sure that you understand the consequences and consider all alternatives first.

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The information provided is not written or intended as specific tax or legal advice. MassMutual, its employees and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel. Opinions expressed by those interviewed are their own and do not necessarily represent the views of Massachusetts Mutual Life Insurance Company.