Retirement Accounts – Borrow Only if You Must

 In Planning Insights

As a general rule of thumb, we discourage borrowing from retirement accounts. However, there is always that exception to the rule where a short-term cash flow need can be satisfied with these types of funds. Here are some pros and cons:

Pros:

  • Usually only a very small fee to borrow from 401(k) as opposed to mortgage, home equity loan or personal loan
  • Most loans process quickly
  • Easy source as participant is borrowing from themselves
  • Can typically borrow up to half of the funds that participant has contributed or $50,000, whichever is less

Cons:

  • Loans are paid back with after tax money and usually over five years. Not only is this double taxing the funds in your 401(k), it is also reducing your take home pay.
  • Must pay interest on the loan amount
  • If participant leaves their employer or is fired, typically only has 60-90 days to repay entire loan or the balance of the loan becomes a taxable distribution and a 10% penalty will be incurred if the participant is younger than 59 ½.
  • Loss of growth of positions that must be sold to make cash for loan available. There are several online calculators that can be used to determine the potential loss, which is helpful in determining how quickly a loan should be repaid and the importance of repaying as quickly as possible.
  • Once participant realizes how easy it is to borrow from their 401K, it can become a slippery slope of ongoing borrowing. A common thought is that it makes sense to take a loan from retirement funds to pay off debt as the interest rate on the retirement loan is typically lower than the rate on credit cards. Keep in mind that funds in a qualified retirement account are safe from creditors. Oftentimes, once the loan is taken and the credit cards are paid off, the credit cards are then maxed out again – the beginning of the slippery slope and the depletion of funds that are actually safe from creditors.

IRA Accounts: You can only borrow from these accounts once every 12 months, not a calendar year, and the funds must be paid back within 60 days.

Qualified Retirement Plans Such as 401(k) Plans:  Each plan has its own set of rules and not all plans allow for loans. Due to the many cons listed above, we encourage our clients to build emergency funds and only think about using retirement fund loans as a last resort.

These funds can be a source of emergency funds for short-term financial needs or true emergencies such as money owed to the IRS. If you “must” draw the funds for true emergencies, then it might make sense. However, if it is for a “want,” sleep on it for 48 hours to determine how important it is, and try to come up with a savings plan rather than borrowing from a retirement fund.