You’re Borrowing from Your Retirement Plan

Posted On: December 24th 2018

If you have a substantial amount of money socked away in a 401(k) or other qualified retirement plan, it may be tempting to borrow from those funds to pay college tuition, credit card bills or other expenses. Before you do, however, be sure to discuss your options with your financial advisor. Given the risks and hidden costs of borrowing from a retirement plan, it should generally be viewed as a last resort.

Not all qualified plans permit loans, but, if your plan allows them, you can borrow up to $50,000 or 50% of your vested account balance, whichever is less. Generally, the loan must be repaid in five years. Often, interest rates are lower than those of comparable bank loans.

Many people view borrowing from a retirement plan as “free.” After all, you’re paying the interest to yourself. But there are costs involved. For one thing, you’ll lose the benefits of tax-deferred growth on the amount you borrow. Unless the interest rate you pay on the loan equals or exceeds the growth rate of the plan assets, your account’s value will end up lower than it would have been without the loan.

Another potential cost is the loss of contributions to the plan (plus earnings on those amounts), either because you can’t afford them while you’re repaying the loan or because your plan prohibits contributions until the loan is repaid. If that’s the case, you’ll also lose any matching contributions your employer offers.

Costs aside, the strongest argument against borrowing from a retirement plan is the risk that the loan will be accelerated if you lose your job or quit. Many employers require you to repay the outstanding balance in the event your employment terminates. If you can’t, the balance will be treated as a distribution and subject to taxes and, if applicable, penalties.

© 2018