Most people agree that cracking your nest egg before you reach retirement age should be considered an option of last resort. But when life throws something unexpected at you – the loss of a job, an illness, or another need to pay for a large expense – you may find yourself looking at borrowing from your retirement savings to meet that need.
You will first need to confirm what options are available to you in your retirement plan. Some options may include early retirement withdrawals, hardship withdrawals and loans. If you have a withdrawal option available in your plan and you understand the potential tax consequences of taking the withdrawal, that might be the right option for you. For those who just need some short term help, a loan might be a more desirable option.
While there are benefits to borrowing from your retirement savings, there are some drawbacks, too. Because there are numerous implications to consider with a retirement plan loan, you should discuss this option with your tax advisor before you consider borrowing from your account.
Beware of the IRS Tax Impact
In regard to retirement savings, the IRS draws a clear line between “borrowing” and “withdrawing.” So a loan from your plan account may involve significant tax consequences if it is not paid back in full by its due date.
If you fail to meet the loan repayment requirements, the IRS will consider the loan a withdrawal, which will be subject to income tax. In addition, you may be assessed a 10% premature distribution penalty tax if you are younger than age 59½.
Weigh Your Options Carefully
Borrowing from your plan account may provide you with lower interest rates and loan fees than you could get from a lender, depending on your credit score. Plus, the interest you pay on your loan goes back into your account, so you’re essentially paying yourself. However, these advantages may not be enough to offset the lost opportunity of long-term growth your nest egg might enjoy if it were left untouched. Also, many plan participants either stop contributing to their 401(k) or reduce their contribution for the duration of their loan, so they also miss out on the employer match.
|Interest and Taxes||· Interest rates are Prime Rate + 1%.
· The interest you pay goes back into your account.
|· Those with a solid credit rating might get a better interest rate on other types of loans besides the 401(k).
· You’re repaying the loan with after-tax dollars, and those dollars will be taxed again when you withdraw them.
|Repayment||· You usually must pay back the loan within five years, although an exception is made if a loan is used to purchase a primary home.||· If you leave your job for any reason, the balance of the loan will become due within 60 days. If you can’t repay it, the IRS will consider the unpaid amount a withdrawal, subject to penalties and taxes.
· Repayments are taken from your net pay (after-tax earnings), so your take-home earnings will be lower.
|Borrowing Limits||· The maximum loan balance can be up to 50% of your vested balance but not more than $50,000 (this limit is inclusive of all qualified retirement plans in which you participate).||· Minimum loan amount is usually $1,000.|
What Borrowing Could Cost You
This hypothetical example* illustrates how taking a loan from your retirement savings may negatively affect your account balance in the long run even when you continue making contributions and especially if you suspend making contributions:
|Account Balance After 30-year Period||Impact on Account Balance|
|Loan Taken and Contributions Continued||$393,693||($959)|
|Loan Taken and Contributions Suspended||$276,483||($118,169)|
* This illustration is hypothetical and for illustrative purposes only. It assumes a $40,000 salary (with a 3% annual salary increase), an ongoing savings plan contribution rate of 10%, 5% annual investment return in the savings plan and the impact of a 10-year loan of $10,000 (with a 4% interest rate) taken after 15 years of saving. The account will be taxable upon distribution in retirement.
The biggest pitfall is if the loan isn’t repaid according to the loan terms. If the loan isn’t repaid, it’s considered a “deemed distribution” of the unpaid loan balance. That means that you now have additional taxable income in the year that the loan was unpaid, although you might have taken the actual cash months or years earlier.
If you’re under age 59½, that deemed distribution will be considered “early” and will also be subject to the 10% premature distribution penalty tax. Since you’ve likely already spent the money sometime in the past when you took the loan, you may not have the funds to pay the taxes.
While the loan feature can be a convenient benefit at certain times in your life, you may want to make sure you have a complete understanding of the full impact of taking a loan from your account.
Press inquiries: Christine Hotwagner
Director, Program Operations
ABA Retirement Funds JoinUs@ABARetirement.com
The information in this article is believed to be reliable. However, this newsletter is distributed with the understanding that the Program is not engaged herein in rendering legal, tax, accounting, investment management or other professional advice.