The Hidden Dangers of Retirement Savings Plan Loans
Borrowing from your employer's retirement plan might sound like a good idea at first blush. It's your retirement savings, after all, and the relatively low interest you pay on the loan goes to yourself instead of a bank or other lender. Unfortunately, the problems with borrowing from your retirement savings go far deeper than the potential loss of future retirement income.
The trouble with borrowing from yourself
Not all retirement plans allow savers to borrow from their account balances held for their benefit. But for those that do, borrowers normally have up to five years to repay, at an interest rate that is usually one or two points above prime rate. The loan payments go back to the account, but those payments are made with after-tax dollars. In other words, you’re pulling out contributions that were made with pre-tax dollars and replacing them with after-tax money. And when you withdraw the amount of the loan in retirement, you’ll be taxed on it again. Ouch! In addition, you may be charged a plan loan origination fee and quarterly fees.
There are other drawbacks. If you leave your job for any reason, the loan becomes due. You may have to pay back the entire plan loan balance in as little as 30 days or you could get socked with taxes and early withdrawal penalties. If you’ve been laid off or fired, that could mean coughing up lots of cash or paying a bigger tax bill and penalty just when you suddenly are without regular income
There's another risk with retirement plan loans for people who are in a financial crisis. Since employer-sponsored retirement savings plan accounts are generally protected in bankruptcy, you may be forfeiting that legal protection for retirement funds you pull out of the account.
Finally, retirement funds taken out of the retirement account isn't working as hard for you as it could even if you do add in the interest payments. If the market has a good run during the time you have the retirement funds, you've missed a lot of upside earnings potential. And the farther you are from retirement, the bigger the eventual hit.
Tapping other options
Fortunately, there are alternatives to taking a loan from your employer’s retirement savings plan.
A home equity loan or home equity line of credit (HELOC) can be used to pay off credit card bills or other expenses, and the interest you pay may be tax-deductible.
Other sources of money to consider:
- If you need money to meet a rising mortgage payment, consider refinancing or consult an FHA-approved housing counselor.
- Contributions to a Roth IRA can be withdrawn tax-free at any time (there are restrictions on withdrawals of earnings in a Roth account, however).
- Borrowing against a cash value life insurance policy carries no tax penalty, although your death benefit may be reduced until the loan is repaid
- For college bills, look first at financial aid, grants and student loans. It's important to remember that when colleges look at parents' finances in making financial aid decisions, assets in retirement savings plans are not counted. Once retirement funds are removed from the plan, however, it can limit your ability to qualify for financial aid.
- If you're really in a financial bind, some experts suggest cutting back hard on your spending and even selling off unnecessary items, such as a boat or a second car. You also should talk to a credit counselor who's certified by the National Foundation for Credit Counseling or a bankruptcy attorney.
Take the next step...
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