from an Employer
Sponsored Retirement Plan
Many 401(k) and 403 (b) participants have discovered a "hidden" benefit to their tax deferred retirement account: you can borrow from it. However, while there are some great advantages to doing so, exercise prudence and understand the subject carefully – there are also some potentially serious disadvantages.
- You have access to potentially large quantities of cash. Most plans offer loans against contributions of up to half of your vested balance (with a $50,000 limit).
- Interest rates for loan plans can be very competitive. They are typically the prime rate plus one or two percentage points – much lower than the rates for the average credit card or unsecured loan.
- There are no restrictions for how you spend the money. It can be used to assist in everything from a financial emergency to a down payment on a home.
- Obtaining a plan loan is convenient and easy – some requiring only a phone call, others filling out a short loan form.
- There is no credit requirement for the loan.
- The typical loan repayment term of five years fits most consumers' needs.
- If you use the plan loan to buy a primary residence, the loan may be secured with the home. Under that circumstance, the interest would be tax-deductible.
- Under most plans, if you leave your job (whether you are laid off, fired, or if you quit), the remaining balance of the loan will be due immediately. That may be the time when you can least afford to pay it back.
- If you are unable to repay the loan, the IRS will consider it a "deemed distribution." You will be taxed on the earnings, and if you are younger than age 59 ½, you will also be penalized 10% for an early withdrawal.
- Obtaining a plan loan can be too easy – if you have spending issues, they may remain unresolved and your retirement savings jeopardized.
- The low interest rate for borrowing against your plan may be misleading. If you borrow money from your plan at 6.75%interest, but the money you pulled out of the account had been earning 15%, then 15% is the real cost of your loan.
- You will lose all future compounding interest on the lost earnings for the amount you have borrowed.
- You could be hit with double taxation. The interest you pay yourself on the loan comes from money that has already been taxed. But the assets in your plan count as untaxed earnings. That means you will pay taxes on that money again in retirement when you make withdrawals from the plan.
- There may be fees for obtaining the plan loan – a one-time fee, maintenance fee, or a combination of the two.