Borrowing money from your employer-sponsored retirement plan may seem like an effective solution to a pressing financial need. But gaining access to your retirement investments in order to enhance your short-term cash flow isn’t necessarily the best long-term strategy. In fact, it could make it harder to achieve financial security later in life.
Read the Rules
If your retirement plan offers a loan option, the IRS allows you to borrow up to 50% of the total vested assets in your account, up to a maximum of $50,000. IRS rules require payments to be made at least quarterly. The loan payments you make (including interest) will be reinvested in your account.
Weigh the Pros
For some, the primary attraction of a retirement plan loan is the simplicity and privacy not generally associated with a bank or finance company. And unlike banks and other sources of loans, there is no need to fear being turned down for the money when borrowing from your retirement plan.
Another benefit may be competitive interest rates. This interest is not tax deductible, however, and may actually “cost” you more than some other types of financing, such as a home equity loan that allows you to deduct interest.
Consider the Cons
While these advantages may make a retirement plan loan appealing, there are several other points you should consider. For example, the loan may require you to pay fees. In addition, if you leave your employer before you fully repay the money, you may be required to repay the balance in full or pay federal income taxes on it. You also could be charged a 10% early withdrawal penalty by the IRS.
Additionally, you should be aware of the potential “opportunity cost” of borrowing from your retirement plan. This is the cost of any potential return you’ll miss out on if the interest rate on the loan is lower than the account’s rate of return. For example, if you borrow money from an account earning 10% and you pay 7% interest on the loan, you miss out on a potential 3% return on the balance of the loan. Over time, those missed earnings could result in less substantial retirement savings.
Finally, take note: Some employers set deadlines for applying for loans and may take up to two months to process the application, so plan carefully if you absolutely must take a retirement plan loan.
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