Retirement Plan Loans: Let the Borrower Beware!
Thinking about taking a loan from your retirement plan? Make sure you don’t sacrifice your long-term goals to meet short-term needs.
Your retirement plan has significant restrictions on withdrawals for good reason, not the least of which is to protect you from yourself - to keep you from using up the money that will most likely be your primary source of income in retirement. Many plans do offer a loan feature, and it is reassuring to know that in case of emergency your retirement assets are available to you. The key word here is emergency - not to be confused with vacation, that new kitchen, or even less frivolous things like college tuition.
Of course, if you have a dire emergency and your only choice is between a hardship withdrawal and taking a loan, the loan may be the right choice to avoid the 10% penalty on early distributions. But for anything short of that, we believe that you should seek other financing alternatives before you tap your retirement plan.
Why? Because taking a loan from your retirement plan can do more damage to your long-term financial goals than you may realize.
Giving Up the Tax Advantage
By taking a loan, you are moving tax-deferred assets into the taxable universe, because you will be using after-tax income to repay your loan. For example, if you fall into a 27% tax bracket, you would have to earn $127 to repay every $100 in principal and interest. And when you take that money out the plan when you retire, you pay taxes on it again - a double whammy.
Sacrificing Growth
A loan also undermines the compounding of your savings, perhaps the most powerful feature of a retirement plan. Since you do not have to pay annual taxes on your retirement plan earnings, the compounding of interest and earnings is especially effective. Don’t underestimate the power of tax-free compounding: just $5,000 in a retirement plan account, compounded annually at 8%, will grow to $15,861 in 15 years. So removing even modest amounts from your plan can significantly affect the growth of your account.
Losing Ground
The potentially most damaging result of taking a loan is that you might have to reduce or suspend your retirement plan contributions in order to repay the loan. A report by the US General Accounting Office underscores this danger, outlining a hypothetical 401(k) account in which a loan was taken to pay for part of a principal residence (see table at left). You can see that even when contributions were maintained, the amount of the loan was never restored. In fact, more potential savings were lost. And when contributions were suspended for the life of the loan, more than 25% of the no-loan balance was sacrificed - in this case, more than a quarter of a million dollars.
Potential Pitfalls
Another factor to consider is that you are required to pay the loan in full if you leave your job. If you fail to do so, or default on the loan for some other reason, the outstanding loan balance is treated by the IRS as a distribution from the plan and is subject to regular income tax. If you are younger than age 59 1/2, an additional 10% excise tax applies.
If you’re still tempted to dip into your retirement savings to meet current needs, ask yourself: “Is the current need important enough to risk reducing my level of income during retirement?” Because taking a loan can have significant financial consequences, consider talking to your financial advisor or tax consultant before you borrow. A professional can help you evaluate the effects of a loan - and explore alternatives to tapping your nest egg too soon.
