Current Thinking

The Pitfalls of Taking a Loan From Your Retirement Plan

A blog by Richard Rausser, CPC, QPA, QKA, Senior Vice President, Pentegra Retirement Services – July 28, 2015

“I might need my money.” This is a remark that is frequently voiced by retirement plan participants – especially inexperienced investors and/or younger employees – when faced with the decision of how much to contribute to one’s 401(k) plan or other retirement savings vehicles.

For such participants, reluctance to tie up a percentage of one’s salary in an investment vehicle for years, if not decades, is understandable. What if an unexpected health emergency arises? What if one is leery of stock market volatility … and subscribes to the old “what goes up must come down” adage postulated by Isaac Newton? What if there is a cool new car that one just cannot live without?

Each of these hypothetical scenarios can be answered with a prompt, “What if they don’t come to pass?”

I am not trying to be flippant here, but, basing any investment decisions – especially when it comes to one’s retirement – on what “might” happen, can, if it is taken to its logical extreme, result in not investing in anything. Ever.

This may not be an advisable approach.

As I have said previously, investing at least 6 percent of one’s annual salary in a 401(k) plan or other retirement savings vehicle is a critical first step to hoping to live comfortably once one has retired. Increasing one’s contribution percentages over time and allowing the magic of compounding to work for one’s account are key components to a successful retirement savings strategy. In addition, what may be most important is keeping the accumulated savings invested in the plan.

It is possible to take a loan from one’s 401(k) plan – something that many participants may not even be aware of (and which it would probably be best if they were not). Although health emergencies may arise, college costs may prove to be even greater than feared, or major home improvements may be required, dipping into one’s retirement savings to address those issues should always be a last resort … or, ideally, no resort at all.

If a 401(k) plan permits loans, a participant can borrow up to 50 percent of his or her 401(k) plan account (or $50,000, whichever is smaller), which amount can usually be repaid over a maximum term of five years (some exceptions do exist). However, taking such a loan may be a great disservice to one’s retirement plan savings – especially when most Americans are not saving enough for retirement in the first place.

Suppose that a participant borrows $10,000 from his or her 401(k) plan to pay for home improvements and is able to repay the loan within one year. Taking into account interest and loan fees, the participant will be paying back approximately $10,700. That may not seem like much of a penalty, but also keep in mind that the $10,000 principal could have been earning interest for your retirement instead of being used for home improvements. (Needless to say, repeating the loan process will further reduce your retirement savings.)

There are other important factors to keep in mind as well when it comes to taking a loan from your 401(k) plan. If you have borrowed from your 401(k) plan and subsequently lose your job, you are generally required to pay back the entire outstanding balance of the loan … often within 60 days of termination of employment. Any amount not repaid within the specified time frame is considered a taxable distribution and may also be subject to an early withdrawal penalty of up to 10 percent.

There is also the fact that a 401(k) plan loan is repaid with after-tax dollars, as opposed to the pre-tax contributions that go into your 401(k). So when you do withdraw that money again in retirement, it will be taxed again … effectively putting you in a situation of paying taxes twice on any loan amounts.

In addition, some retirement plans do not allow you to make new contributions to your 401(k) plan if you have an outstanding loan – not a situation in which you want to find yourself, if at all possible. So what can you do if an unforeseen expense arises? Explore getting a bank loan. Liquidate non-retirement assets. Ask a concerned family member or friend for the money. Consider any and all alternatives before you borrow from your 401(k) plan.