Need Money? Personal Finance Tips When Borrowing from a Retirement Account

Need Money? Personal Finance Tips When Borrowing from a Retirement Account

borrowing from a retirement account

When you're in a bind financially, it can be very tempting to turn to your nest egg for a quick cash infusion. After all, you're just borrowing it and have every intention of paying it back. However, "taking a loan from a 401(k) plan is often a last resort," according to Anika Hedstrom, MBA and Senior Financial Analyst practicing in Southern Oregon.

Loan Limits

If you're looking to borrow from a retirement plan, it has to be an employer-sponsored plan, like a 401(k) or 403(b). IRAs -- even those offered by an employer, like SEP-IRAs or SIMPLE IRAs -- aren't eligible to offer loans. Even with 401(k)s and 403(b)s, it's up to your employer whether or not the plan will offer loans. "It may not even be an option, as plans are allowed, but not required, to provide this service," says Hedstrom. If you can take a loan, you're limited to $50,000 or half your vested account balance, whichever is less. For example, if your vested account balance is only $30,000, you can't borrow more than $15,000.

Loan Considerations

"Before taking a loan, it is important to first evaluate what the funds will be used for, as 401(k) or other employer-sponsored qualified plans are generally a protected asset against creditors and bankruptcy," cautions Hedstrom. For example, if you take money out of your 401(k) and pay for a vacation, you might save money on interest charges versus putting the cost on your credit card. However, if you lose your job and end up declaring bankruptcy anyway, you'll lose out. If you hadn't taken the loan, the credit card debt would likely have been discharged and the money would still be in your 401(k).

Loan Costs

Taking out a 401(k) plan isn't cheap, especially considering you're borrowing your own money. According to Hedstrom, "There is generally a one-time loan origination fee that can take upwards of 7 percent off the top (i.e. you take out a loan for $1,000 and the fee is $70) not including the interest you will pay for the duration of the loan, usually the current prime rate plus 1 or 2 percent." So, it's to your advantage to minimize the amount you have to borrow so that you can cut down on the original fees and keep as much money in your 401(k) plan so it can continue to grow.

Repayment Requirements

Before you borrow, make sure the loan repayments fit in your budget. Your employer generally takes the money directly out of your paycheck, and, unlike original 401(k) contributions, you won't get a tax break. "When you take a loan from yourself, you are taking pre-tax money out of your account and repaying the loan with after-tax money," says Hedstrom. Usually, you have to repay the loan within five years, but you can use a longer term if you're using the loan for your primary residence. However, that longer term won't help you if you leave your job -- even if it's not your fault. "If you lose your job, you may be forced to pay off the loan quickly, and if you are unable to do so, then you pay taxes and penalties like an early withdrawal," cautions Hedstrom. For that reason, if your job isn't stable, you might want to look for other funding for your loan.

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