The pros and cons of borrowing from yourself
If something comes up and you absolutely need to take a loan, you might have an opportunity to borrow from your retirement savings account. And while it may seem like an easy option, borrowing from yourself isn’t always a great idea. Below, we’ve weighed some of the pros and cons of taking a loan from your retirement plan.
PROs: Why borrowing from your retirement savings is the natural choice
- Obtaining a plan loan is usually easier than getting a loan from a bank or other commercial lender. If you have the required minimum balance in your account and meet your plan’s other requirements, you should qualify.
- Most of the interest you pay on a plan loan goes back into your plan account, with a percentage used to pay for the loan administration.
- In some cases, you can repay the loan through payroll deduction, so you don’t have to remember paperwork or repayment schedules. In other cases, you’ll be given a coupon book to help you remember to make payments.
Always check with your plan administrator to learn about the exact terms of your plan and take note of any fees you may be charges, as well as any other restrictions.
CONS: When another option might be a better choice
- You can only borrow so much. You can typically borrow up to half the vested amount in your retirement savings account, but no more than $50,000. If you already borrowed money within the past 12 months, then the balance of the loan will be subtracted from your allowable amount. Depending on how much you need, you may not be able to borrow enough from your account.
- You’ll pay taxes twice. You will pay back the loan using after-tax dollars, then you’ll be taxes again when you take the money out at retirement.
- The loan must be paid back within five years. If you leave the company before you fully repay the money, you may be required to pay the balance within a short window of time or pay federal income taxes on it. You could also be charged a 10% early withdrawal penalty by the IRS. (An exception to the 5-year rule is if the loan is acquired to purchase a primary residence. In this instance it is extended to up to 30 years.)
- You could end up with less money. The long-term cost of borrowing from your plan is a potentially smaller retirement nest egg. Although borrowing from your plan reduces your plan balance only temporarily, you could miss out on investment returns that you might have earned if you had left the money in the account. Those returns could potentially exceed the interest you will have to pay yourself on the loan.
The specific terms of the loan -- frequency of payments and the interest rate -- will be determined by your plan, which may allow you to make payments on a loan through payroll deduction.
Let’s look at a simple example. Say you’ve got two employees that are exactly the same. They both contribute $6,000 to their 401(k) balance (same funds), and both plans grow at an average annualized rate of 8% each year.
But the two employees treat their accounts differently. Employee A simply continues at the normal pace of adding a $6,000 per year contribution to his 401(k) plan.
Employee B decides around Year 11 to borrow $40,000 for a home purchase.
The loan generally needs to be paid back within five years, although you can usually get this term extended up to 30 years if the purpose was for a house. Employee B now has to put $8,000 per year back into his plan (plus interest and fees). Because of that, he will likely discontinue his original $6,000 contributions to cover the new $8,000 payments he has to pay back to his 401(k) plan. At the end of five years when the loan is paid back, he then resumes the $6,000 contributions.
After 30 years, how much more money does Employee A have?
Think carefully before borrowing from your retirement savings
By taking a loan of only $40,000, Employee B has ended up with $150,000 less for retirement. While buying a home is an important purchase, saving for retirement is an equally important endeavor. Therefore, you may want to consider other loan options for purchasing a home or paying other expenses, before defaulting to your own plan.
Important Note: Equitable believes that education is a key step toward addressing your financial goals, and we’ve designed this material to serve simply as an informational and educational resource. Accordingly, this article does not offer or constitute investment advice and makes no direct or indirect recommendation of any particular product or of the appropriateness of any particular investment-related option. Investing involves risk, including loss of principal invested. Your needs, goals and circumstances are unique, and they require the individualized attention of your financial professional. But for now, take some time just to learn more.
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