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Should you take a loan from your retirement account?

In the wake of the pandemic, many Americans have lost their jobs and are struggling to make ends meet. One avenue is to take a loan from their retirement accounts. But should you? This question suggests a multitude of responses and is one of the most frequently asked questions by retirement participants. Let’s take a deep dive and review the pros and cons, but we’ll start with the basics.

Your retirement plan provides a powerful savings vehicle for when you will need it most, at retirement. It’s important to note that not all retirement plans allow for loans. Since a 401(k) loan doesn’t really have a lender, you’re withdrawing money from your own account on a tax-free basis and repaying the loan to your 401(k) account together with the interest rate applied (prime interest rate plus 1%). The interest rate charge in essence repays your account for potential growth on the money you withdrew.

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There is typically a minimum loan amount you may take, based on your needs, which is 50% of your vested account balance but not to exceed $50,000. Vesting refers to the portion of the account balance you fully own. The dollars you contribute from payroll are always 100% vested and any employer money contributed may be subject to an annual vesting schedule; the longer you’re with your employer, the great portion of the dollars they contributed you get to keep.

The minimum loan amount is typically $1,000 so you’d need to be 100% vested in $2,000. For a general loan, the max you can withdraw is $5,000 payable within five years. A loan for the purchase of your principal residence can be made for up to $50,000 (you’d need a vested account balance of $100,000) and you’ll be allowed a great repayment period.

The Pros:

  • If the plan allows for loans, you have dollars available to you based on your employer’s retirement plan documents for a general loan or purchase of a primary residence. If you’re unsure if your plan allows for loans, check with your Human Resources Department, and they can review the rules under the Summary Plan Description (SPD) document, which you should receive annually.
  • Applying for the loan is fairly simple and quick. You can complete loan paperwork or initiate the loan online.
  • Through payroll deduction, you’re repaying your retirement account with interest.
  • The loan is made on a tax-free basis.
  • Loan repayments are made in equal installments until paid in full.
  • There is no credit lender.

This all sounds simple, doesn’t it? Well, let’s take a look at the flipside.

If the plan allows for loans, you may first be required to take a hardship withdrawal. Hardship withdrawals come with their own set of rules which you may not qualify for; the rules can be found in the SPD.

Although you’re removing dollars on a pre-tax basis, your repayment is made on an after-tax basis. Let’s take a look at Tom. He takes a loan from his retirement account for $5,000 and he’s only contributed pre-tax dollars. Over the next five years, Tom faithfully makes his payments. Tom is repaying his loan with ‘after-tax’ dollars. Do you see the issue? Well, Uncle Sam’s not watching closely either. Now that Tom has paid taxes on the $5,000 loan, he gets to pay Uncle Sam again when he retires after the age of 59 ½. That’s double taxation on the loan!

On another note, when you remove dollars from your 401(k), you’re forfeiting the ability for the dollars to move with the market, possibly gaining greater growth than the interest you’re repaying your account.  Not to mention, if you take out a loan when there has been a market downturn, you’re removing dollars from a balance that has already been decreased.

Tom could quit his job, be laid off or worse, get fired. What happens to his loan now? If he doesn’t pay the loan in full, he’ll receive a 1099 in January of the following year to claim any outstanding loan balance as income to him for the prior year. Tom is younger than age 59.5, he’ll owe a 10% early withdrawal penalty as well.

The Cons:

  • You might be required to take a hardship withdrawal first before applying for a loan.
  • You can’t borrow more than the legal limit.
  • You may miss potential market gain greater than the interest repayment.
  • Double taxation.
  • If the loan is not repaid before leaving your employer, the balance is subject to income in the year the loan defaulted, and a 10% early withdrawal penalty is also applied if the participant is younger than age 59.5.

The decision to take a loan requires careful consideration and isn’t as simple as it appears. Your retirement account should be viewed as a long-term investment to get you to the future you’ve worked so hard to attain.

Please review this blog, Coronavirus, Aid, Relief and Economic Security (CARES) Act FAQs, as the Cares Act provides relief through some loan provision changes. Contact your Henry+Horne Wealth Management advisor with any questions. For more information and resources on COVID-19, see our coronavirus page.

Angie Kaufman