Retirement plan loans: Think carefully before you borrow

This article will ... Go over the rules for taking a loan from your 401(k) or other type of retirement plan. List five distinct challenges to consider that may have serious consequences for your finances. Review the likelihood of default as well as tactics to avoid default in the first place.

An unexpected financial crisis has you scrambling. Tapping into your retirement plan may provide some initial relief but can cost you significantly more than you might think. Make sure you understand the risks of a retirement plan loan, and don’t let a short-term solution disrupt your long-term security.

Retirement plan loans: Know the rules

If your employer’s plan allows loans, there are a few rules you must follow:

• You must sign a loan agreement that explains the terms of the loan.
• You must pay a reasonable amount of interest for the loan (albeit to yourself).
• The loan generally cannot exceed 50 percent of your vested account balance or $50,000 within a 12-month period—whichever is less.
• You must repay the loan within five years (unless used to purchase a principal residence or you are on active military duty).
• You must make loan repayments regularly, in equal payments that include principal and interest.
• You may need consent for the loan from your spouse / domestic partner. 

Things to consider before taking a loan

Although borrowing your own money sounds like a good idea, here are some things to think about before taking a loan from your retirement plan account.

• Fees – Many record-keepers charge fees for issuing the loan and tracking payments and interest.
• Opportunity cost – You are removing money from your retirement account that could potentially be earning more than the interest you are paying. If there is an upswing in the market, you will miss it. Plus, you miss out on the power of compounding interest.
• Pay tax twice – Your loan repayments are deducted from your paycheck after taxes have been withheld, but they go back into your account as pre-tax assets. You will pay tax again on that money when you start taking distributions.
• Reduced savings rates – If you are taking a loan to pay off debt or because you are having a tough time making ends meet, you may not have enough money to both repay the loan and continue contributing a portion of your pay into the plan. Some people stop saving altogether while they are repaying a loan, further shortchanging their retirement. (Related: Why your 401(k) might not be enough)
• Potential taxes and penalties – Some employers require that you repay any outstanding loan within 60 days of leaving your job. Any unpaid balance would be treated as taxable income and there may be additional tax penalties on top of that.

Loan defaults happen

And they’re quite common. In fact, 86 percent of people who leave their job with an outstanding loan balance go into default.¹ If you fail to repay your loan or break any loan rules, you not only lose a portion of your retirement savings, you also must treat the defaulted loan amount as a distribution, which is taxed as ordinary income. (Related: Borrowing from your 401(k): The risks)

If you are younger than age 59½, you will owe a 10 percent early distribution tax in addition to income tax. Even though it may seem like you took just a small amount out of your retirement savings, the taxes and loss of compounding interest could have a significant financial impact.

Preventing defaults

The only sure way to prevent a loan default is by not borrowing from your retirement account in the first place. Protect yourself today by planning for future financial surprises. Here are some tips:

1. Set up an automatic deposit into a savings account each month for an easy way to save. You can do this from your primary checking, but your payroll department may make it even easier if they allow you to send a portion of your paycheck directly into a separate emergency savings account.
2. Consider using a different bank from your checking account. You’ll be less likely to dip into it for non-emergencies.
3. Help yourself avoid temptation by not attaching a debit card to the account.
4. Jump start your emergency fund by setting aside a portion of a tax refund.

Next steps

It’s easy to lose sight of the reason for your retirement plan savings—it’s your money, and it will pay for your living expenses in retirement. Consider this account off limits unless you really need it. If you must borrow money, do your research first. Compare the fees and interest rates for a line of credit, a home equity loan, and a personal loan in addition to a retirement plan loan.

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