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One of the drawbacks of borrowing from your retirement plan is that the loan amount is no longer being invested and could thus mess up the diversification ratios until the sum is returned to the plan. However, when you take a loan, the loan amount will be treated as an asset in the plan, as it will be replaced by your promissory note. Remember that diversification comes with risks, and the possibility exists that you could have a negative return on your investments unless some of your investments have a guaranteed rate of return.
Therefore, the advantage of taking a loan from your account is that you will receive a guaranteed rate of return on the loan amount. One of the arguments against taking a loan from your retirement plan is that the amount you repay in interest will be double taxed.
This is because the loan repayments , including the interest, will be made with amounts that have already been taxed and will be taxed when withdrawn from the retirement account. Let's look at an example. With a few narrowly defined exceptions, loans taken from your retirement account must be repaid at least quarterly, and they must be repaid in level, amortized amounts of principal and interest.
If you leave your employer before the loan is repaid, you may be required to repay the entire balance within a short period, instead of over the established schedule. If you are unable to repay the balance, the plan may treat it as a distribution offset. The loan would thus be treated as ordinary income unless you have available funds to replace the amount as a rollover contribution to an eligible retirement plan within 60 days after the date the offset occurs, or you are eligible to complete a direct rollover of the promissory note to another qualified plan.
You should take loans from your retirement plan only if you have exhausted your other financing options, or if the loan will help to improve your finances. Let's compare the two scenarios.
If you do take a loan from your retirement account to pay off your credit card balance , make sure you take steps to avoid accruing new indebtedness under the credit cards. Check with your financial planner for assistance in this area—they can also help you ensure that your credit score is not adversely affected.
Another good reason for taking a loan from your retirement account is to use the loan amount to purchase a home. As industry trends show, amounts invested in your home provide a significant return on investment.
Furthermore, you could also use your home to finance your retirement, whether by selling the home or by taking a reverse mortgage. The government makes easy, low-cost loans available for college, but not for your retirement. Not all qualified plans allow loans, and some that do will only allow them for special purposes such as purchasing, building, or rebuilding a primary residence, or paying for higher education or medical expenses.
Others allow loans for any reason. Your plan administrator will be able to explain the loan provisions under your retirement account. If you must take a loan from your retirement account, try to continue making contributions and increase the amounts you contribute, where possible.
This may be a challenge, as you will also be required to make loan repayments, and those repayments will not be considered contributions to your retirement account. However, it will help you restore your nest egg much faster.
Most plans will allow you to accelerate your loan repayments, which will help to restore your plan balance more quickly. Be sure to factor your loan repayment into your budget. This will keep you from overspending. You should not take a loan from your retirement account unless it is an absolute necessity or it makes good financial sense. Determining whether a loan is right for you requires an assessment of your financial profile and a comparison of the loan option with other options, such as taking a loan from a financial institution if available or paying off credit card balances over time.
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. 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. 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. After 30 years, how much more money does Employee A have? Take the next step Find out how much income you could have when you retire.
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