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Avoiding The Pitfalls Of Borrowing From Your Retirement Plan

I will spare you a lecture about why you should not borrow from your retirement plan.  You know it is money set aside for your retirement, and you are an adult.  Last year, 18% of retirement plan participants borrowed from their accounts.  It is widely expected that the figures this year will be considerably higher once 2008 statistics are available.  If you have run out of options, and are considering making the move to tap into your retirement funds, today’s blog is an overview of the process and how to avoid the pitfalls. 


The Basics Of Borrowing From Your Company Retirement Plan

About 85% of of participants in 401k plans can borrow against their account.  Depending on the plan, there may be restrictions on the amount and the use of the borrowed money.  For example, some plans allow loans for the purchase of a home, medical expenses, education, or a financial hardship.  Other plans have no such restrictions.  Most plans also have a maximum you can borrow, which is usually $50,000.  Of course, this is based on how much money you actually have in the plan.  You can generally only borrow up to 50% of your vested account balance and loans must be repaid within five years.  You will also have to pay interest, but the interest is being paid back to your own account (you are paying yourself).  In fact, the latest craze are debit cards that are funded by your 401k account balance.  Most financial experts think this is a very bad idea which makes spending retirement money much too easy.  

403b’s vary, but more and more of these plans (for non-profit organizations) allow participants to take loans against their accounts as well. 

What Happens If You Change Jobs While You Have A Loan Outstanding? 

One of the big pitfalls of borrowing against a retirement account is the possibility (especially in this economy) of changing jobs.  If you separate from service (which can be voluntary or involuntary), you must repay the loan in full within 60 days.  If you do not repay the entire loan within the 60 days, the loan is considered defaulted and treated as a withdrawal.  On 401K’s and 403b’s you must be at least age 55, or you will also be required to pay a 10% penalty in addition to income taxes on your withdrawal.  Note that the age to avoid the penalty is 55 on a 401K, but is 59 1/2 on other retirement accounts such as IRA’s (more on IRA’s coming up).  If you end up in this situation and expect to avoid the penalty, you should consult a tax adviser since the rules are very tricky.  I want to make clear that money withdrawn from these types of plans is subject to income taxation regardless of age. 

What If You Default On A Retirement Account Loan?

If you don’t make your payments and your loan goes into default, the consequences will be the same as above.  The amount of the loan that remains unpaid will be considered withdrawn and subject to applicable income taxes and the additional 10% penalty (based on your age).

Is it Ever Wise To Borrow Against Your Retirement Account?

If you have high interest rate debt, or are considering borrowing money at a high rate, you may be better off borrowing from yourself through your 401k.  A good tool to use is a 401k withdrawal calculator such as this link to one provided by American Century Mutual Funds.  You must factor in the loss of earnings on the money that may have otherwise occurred while it was in your account, your tax bracket, the interest rate of your other loan options.  This calculator is a great tool to help make sense of all of these variables.

Can You Borrow From An IRA?

There is no official method to borrow from an Individual Retirement Account.  One way to legally take a short term loan is to do an IRA Rollover.  The IRS allows you to withdraw money from an IRA as long as you deposit it within 60 days into a new IRA account.  This movement of money (called a rollover), can be done once per year.  The 60 days is a grace period and intended to give you the time needed to move your funds.  Nonetheless, during the 60 days you can do whatever you want with the money.  You can only do this one time each 12 months.  Remember, you are given 60 days not 61 to put the money into a new IRA account.  This rule is very strictly enforced, don’t expect to be able to get even one extra day from the IRS.

Suze Orman Says Never, Ever, Ever, Borrow From A 401k

Final Thoughts

Borrowing from a retirement account is usually not a good idea, although I will concede that there are always exceptions to the rule.  I think it is important to get the details on your retirement plan loan options from your employer, so that you can make an informed decision if need to take a loan.  I am not as dogmatic as Suze Orman or other TV financial advice givers.  Life can hit you with some real curves (don’t I know that) and tapping into a retirement account to fund a necessary medical procedure, or other hardship may make sense.  Getting a 401k debit card and using it for going out to eat, vacationing, or other discretionary purchases is clearly poor stewardship. 

Helping you make the most of God’s money!

James L. Paris
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