Ballpark Estimate: Up to $350 in plan fees for a 5-year loan plus the cost of interest
If you are in need of money for some sudden or unexpected expenses, you may be tempted to borrow from your retirement account. This can be an easy-to-access source of funds to get you through an emergency situation. Yet some experts warn that this loan doesn’t come without significant costs and responsibilities. Therefore, you should be prepared to get all of the facts before deciding if this is your best option.
Most 401(k) and 403(b) retirement plans allow participants to take out a loan from their retirement balance. The details can vary depending on the plan specifics, but the concept is basically the same in most cases. You borrow from the balance you’ve saved, and then agree to pay it back to yourself, along with interest, at prearranged intervals.
How It Works
When you borrow from your retirement, you are basically taking out a loan the same way you do when you take out a mortgage or a car loan. The specifics of the loan can vary from plan to plan, but the general guidelines restrict the amount you can take in any plan to be half of vested balance, up to a maximum of $50,000. (However, if you have less than $10,000 vested, then you can often take out the full amount.) Repayment is usually arranged over a time period of one to five years.
The Pros And Cons
On the surface, borrowing from your retirement fund may seem like a very good idea. Since you are borrowing the money from yourself, there is no credit check needed and often you can access the money quickly and easily. In addition, you make your payments, along with interest (usually one or two percent over prime), back into your own account, rather than giving the money to a bank or other institution. This can be an appealing concept.
On the flip side, though, some plans require you to stop making contributions until your loan is paid back. And if you normally get an employer match, this means you are missing out on this benefit as well. Further, when you withdraw your money while the stock market is down, you may sell your stock at a loss. Or, if you sell when it’s up, you may miss out on further gains and may also have to spend more to buy the stock back later, so there are missed growth opportunities that you must factor into the equation, particularly when you realize that the larger your balance, the faster the money grows for your future, and vice versa.
Other Things To Consider
If you borrow against your retirement fund, you must be sure you will be able to make the payments, which may be due weekly, monthly or quarterly. You should also understand that if you leave your employer under any circumstances, you may be required to repay the balance of the loan immediately (or within 30 to 90 days in some cases). If you are unable to repay the full loan in time, you will be responsible for income tax on the balance due, and if you are under age 59½, you will also be subject to a penalty of 10 percent of the amount for withdrawing early.
When It Makes Sense
If you are deciding whether it makes sense for you to take out a loan from your 401(k), many financial experts say that it depends on what the money will be used for. For instance, you would not want to use your retirement fund to pay for a vacation or to buy a new car. But if you have unexpected medical bills or need it to help pay for an essential repair on your home, if you have nowhere else to turn for help, this may be a feasible last resort, especially if you will be able to repay the loan within the specified time period.
In addition, some people find it feasible to take out a retirement loan to buy a home. You can often stretch out the repayment of a loan for a home for as long as 15 years.
What It Costs
The cost of borrowing from your retirement can be very complicated to determine. There are straightforward costs, such as a loan origination fee, which can be a one-time charge in the range of $100, then some plans charge maintenance fees which can tack on another $50 or so annually, (which would add up to about $250 over a five-year period). Then there is the cost of the interest you will be charged on the loan. This is often prime plus an additional percent or two. But remember that you pay the interest back to yourself, rather than the money going to an institution the way it would with conventional bank loan. This means that you be adding a little extra money to the balance throughout the repayment period. Just keep in mind that the amount of the interest you pay back often doesn’t equal the interest you might have earned on money if you had kept in your account in the first place.
There is also the cost of paying taxes on the loan. This is because your initial contributions into the fund were taken from your pay check without any taxes taken out of them. However, when you borrow from your balance and then repay it, the money you repay it with is taxed this time. This means that if 27 percent of your income goes to taxes, then for every $1 you take out of your retirement fund, it will cost you $1.40 to repay the same amount. Further, when you go to retire and pull money out of the account, the federal government will be taxing the money at that point. So you will in essence be paying taxes twice on the amount you borrowed, both now and again later.
Another important cost occurs when you pull money out of your fund, since you are losing the opportunity for the money to grow. This can be a significant loss, although it is hard to calculate since you don’t know what the actual rate of return would have been for that time period until it is paid back. In addition, if you are prohibited from making contributions during this period, that is more lost growth and also lost employer match, so this adds up, too.
So the cost of a borrowing from your retirement account for five years includes:
- About $350 in plan fees.
- Interest on the amount of the loan at about prime plus one or two percent.
Double-taxes on the loan amount (since repayments are taken from post-tax dollars, and you will also pay interest on the amount again when you withdraw it in retirement.)
- Lost interest on the money, plus the loss of it compounding.
- Loss of your employer match while you are repaying the loan amount.
Other Taxes And Penalties
If you are unable to pay back the amount you borrow in the timeframe designated by your plan, then the loan will be treated as an early withdrawal. This will even further increase the costs. You will be responsible for a 10 percent penalty, plus you will be taxed on the money at your normal income tax rate (such as 27.5 percent). If your taxes and penalties add up to almost 40 percent, this means that a $2,000 loan will only leave you with about $1,200. That’s a significant difference, especially when you consider the fact that the original $2,000 would have grown to be a lot more over time.
Before taking money from your retirement account, the experts suggest considering other options if possible that could be more feasible and have less of an impact on your retirement savings down the road. You may want to look into the terms of a bank or home equity loan and weigh the pros and cons of each to see what makes the most sense.
A Final Note
Remember that retirement plans all have different terms, so you will want to find out exactly what is involved for your specific situation. Always consult with a financial planner for advice before making any decisions. You can also visit the IRS website for federal rules and regulations.