Did you know you could actually borrow from your 401(k) or 403(b) and pay it back without penalty?
The IRS permits you to take a loan from your employer sponsored retirement plan (not available for IRAs), as long as your employer’s plan allows loans. However, just because this option is available, doesn’t mean it’s a good idea. Knowing the impact of borrowing from your retirement account is important to understand before pulling the trigger.
Rules For Borrowing
The IRS generally requires you to be 59 ½ to access your retirement funds, but has made special provisions for borrowing.
Plan must allow loans
Maximum Term is 5 Years
Maximum Loan Amounts
Minimum Loan Amount
Fees and Charges
You employer is not required to allow loans from the 401(k) or 403(b) plan. If loans are allowed under the plan, you can visit your HR office to obtain the paperwork or contact information for the plan sponsor who would draw up the loan from your account.
Most plans will allow you to customize the length of the loan from 1-5 years. Currently, IRS rules will not allow you to pay back the loan for more than 5 years.
You can borrow up to $50,000 or half the value of your account – whichever is the lesser of the two. For example: If you have $90,000 in your 401(k), you can borrow $45,000 because this is half or the balance and it is less than $50,000. If your balance was $120,000, you can borrow a maximum of $50,000.
For many retirement plan, a loan minimum of $1,000 is common. Check with your plan sponsor to see what the minimums are for your specific plan.
Employer retirement plans can charge a fee to administer the loan. Generally there is a set up or initiation fee that can be from $100 – $200 and is usually added to the borrowed amount. In addition, there are sometimes annual fees for maintaining the loan, and these can vary from plan to plan.
Pros of Borrowing From Retirement Account
No Early Withdrawal Penalty or Taxes
Low Fees and Interest Rates
Pay Yourself Interest
Borrowing from your retirement account allows you to avoid the 10% penalty of withdrawing your funds before reaching 59 ½ years of age. Since the funds are still considered as a part of your retirement plan, you are not taxed on the funds you borrow.
Most retirement plan loans will have low rates and reasonable fees compared to a personal loan at a bank or credit union. (See the Fees and Charges above)
One of the nice parts of borrowing from your retirement account is that most of the interest goes right back into your account. It’s as if you are paying yourself the interest that should have been accruing. I’ve seen some plans that have interest rates of 5% but 4% goes into your account and only 1% is kept as administration fees – translating into basically a 1% loan!
Cons of Borrowing From Retirement Account
Contributions May Be Frozen
Defaulting on Loan
Cannot Make Additional Payments
Accessing Long Term Savings is Dangerous
Sometimes plans will force your contributions to be stopped for the term of the loan. This makes a loan unattractive because it means your retirement account will lose momentum and it can really impact your ending balance.
Although defaulting on your loan doesn’t hurt your credit, it does turn the loan into taxable income. This means if you default on a $20,000 loan, you are responsible to pay taxes on the extra $20,000 now added to your income and that might just push you into a new tax bracket.
Many retirement loan repayment plans don’t allow you to make extra payments to your loan. You can either make the payments or pay it off in full. Saving those extra payments until you can pay it off in full is a good strategy for paying it off before the term.
Let’s face it; Americans don’t have enough saved for retirement as it is. Tapping into your retirement account for any reason can be dangerous for your financial future, especially if your employer freezes contributions during the term of the loan.
Borrowing from your retirement plan can be a good option if used correctly. It can also be a terrible decision if you aren’t disciplined. If you’re borrowing to pay down credit card debt, take some time to really think about the reason you’re in credit card debt in the first place. If you’re borrowing for college, I suggest considering a government loan first or to look into other saving options first.
Have you ever borrowed from your retirement account? In your opinion, what would be a good reason to borrow?
Tim is a personal finance writer at Faith and Finance a Christian financial help blog that provides financial insights for individuals, businesses, and churches. Outside of finance, Tim enjoys spending time with his wife, playing the saxophone, reading economics books, and a good game of RISK or Catan. Find him on Twitter and Facebook and subscribe to the Faith and Finance RSS feed.