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Education Center » Borrowing From the Bank of You: Taking a loan from your retirement account

Borrowing From the Bank of You: Taking a loan from your retirement account

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Since the day you enrolled in your employer’s retirement plan, your retirement account has been earmarked for one of the biggest expenses you’ll ever face: retirement. Once you retire, it could be your primary source of income, used to pay for everything—from groceries and prescriptions to utility bills and travel expenses.

Whether it’s a home renovation project, an extensive car repair, or unanticipated medical expense, chances are you’ll encounter an unexpected expense before you retire. If you do, you might consider taking a loan from your retirement account to cover it.

You may think that a 401(k) loan seems like a good option. After all, it’s money you’ve already earned and put aside, and of course, you’re totally planning to pay it back. But, in some cases, raiding your retirement account before you retire is not the best option. So, before you make your decision, take time to review the potential benefits and the potential drawbacks.

When it might make sense to take out a retirement plan loan

Some experts say that you should never take a loan from your retirement account, because of its potential to derail your retirement investment progress. Yet, the truth is that there are a few circumstances when you may want to consider it.

You need fast access to cash – If you’re in an emergency situation and need money immediately—say, to repair your home after a natural disaster or to deal with an unforeseen medical situation—a loan from your retirement account might be a viable option.

It makes financial sense for your situation – In some cases, a plan loan, even with all its potential drawbacks, might help you get out of a bad financial situation. For instance, you may be able to pay off a high-interest credit card. You will generally be charged an interest rate similar to the rate you would pay for a bank loan, there is no credit check, and you pay the interest to yourself rather than to a bank or credit card company.

You need it to make a down payment on a home – If you’re considering purchasing a home, a higher down payment could lower the interest rate on your mortgage in some cases. Just remember that if you take out a loan from other lending sources, the interest typically will be tax-deductible. That’s not the case with a retirement plan loan.

How plan loans work

Many retirement plans allow you to take a loan up to (1) the greater of $10,000 or half of your vested account balance or (2) $50,000 minus any outstanding loan balances*—whichever is less. General purpose loans must be repaid within five years, or it will be treated as a taxable distribution. However, a loan used to purchase your primary residence can be paid back over a longer period of time without being treated as a taxable distribution.


* The $50,000 maximum loan amount is further reduced by the highest outstanding loan balance for the participant in the 12-month period preceding the date the participant initiates any new loan.

However, think about tomorrow’s consequences before you borrow for today

As appealing as it may seem, taking a loan from your retirement account has potential disadvantages.

You’ll reduce your take-home pay – Understand that loan payments will come out of your paycheck (as they ultimately would for any other loan). This means that until your loan is paid in full, you’ll have to learn to get by on less. Before pulling the trigger, be sure to calculate the net effect on your take-home pay.

You may lose momentum – Due to your reduced take-home pay, you may need to reduce the amount of contributions to your account while your loan is outstanding, depending on your disposable income. In addition, although not common, some plan loan policies won’t let you make additional contributions to your account until your loan is paid in full, essentially causing you to put your retirement investment progress on hold.

You might face additional taxes – If you lose or leave your job before your loan is paid off, you may be on the hook to pay the loan back in full in a short time period, or it will be treated as a distribution and taxed accordingly. The outstanding amount may be subject to federal and, if applicable, state income taxes, as well as an additional tax for early withdrawal if you’re under age 59½, unless an exception applies.

You could miss out on valuable compounding time – When it comes to investing for a long-term goal like retirement, time truly is money. That’s because of compounding—the ability to potentially earn money on your money. With compounding, the money you invest has the potential to grow, and those earnings may also grow. When you take your money out of the market, you might miss out on valuable, “money earning money” compounding time.

Important note about the CARES Act

Please keep in mind that this article does not include details about the Coronavirus Aid, Relief, and Economic Security (CARES) Act. To see how plan loans may be affected by this Act, please consult your 401(k) plan documents.

When it may not be a good idea

There are a few situations where you may not want to take a loan from your plan account—for example, to pay for college. The argument against borrowing from retirement to pay for a child’s college education is simple: generally speaking, college loans are readily available (and the interest is potentially tax deductible); however, you cannot borrow money to pay for retirement.

Explore other options

Before you consider taking a loan from your retirement account, make sure you’ve exhausted other available options. Not sure where to start? A financial professional and/or tax advisor can help you explore other avenues for loans.

One way to avoid dipping into your retirement account prematurely is to start an emergency fund. By putting aside a little money every month, you’ll have a source of ready cash the next time an unexpected expense crops up.

Whatever you do, don’t let your short-term needs derail your long-term goals. By not tapping into your retirement account now, you may be better prepared to fund your future, whatever it may hold.

Learn more and take action

  • If your employer’s 401(k) plan is with Merrill and you have questions or need help evaluating a loan, visit Benefits OnLine® or use the Benefits OnLine® app.
  • Learn more about 401(k) loans.
 
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