This Is When You Should Borrow From Your Retirement Account
Building a retirement nest egg takes time and effort.
In a perfect world, this is money that you are not supposed to touch until you are least 59 1/2 years old. Nonetheless, when life throws you a curve ball, you may have to take a loan or withdrawal from your nest egg. (See also: Balancing Retirement, Emergency Fund, and Debt)
The first step is to contact your plan manager and verify whether or not you can take out a loan. Not all qualified retirement plans provide the option to borrow. For example, the IRS states "loans are not permitted from IRAs or from IRA-based plans." On the other hand, 401(k) plans, money-purchase pension plans, and profit-sharing plans are examples of plans that allow you to borrow.
You'll also need to determine how much you can borrow. Most plans limit you to half of your vested account balance, up to $50,000. Even if your vested retirement account balance is $200,000, the maximum you can borrow is $50,000.
The most important thing though is to do it for the right reason. Here are three scenarios when you should consider borrowing from your retirement account.
1. Your Employment Is Stable and You Can Pay Back the Loan Within Five Years
You need to evaluate your current job situation:
- How did your last review go?
- Is your current job secure for the next couple of years?
- Are you happy with your current job?
If you are fired, then your loan becomes due. No job and a big loan to repay is a bad combo! Your loan also becomes due if you switch jobs.
You also have to be sure that you can pay back the loan in full within five years. Otherwise, you will face stiff penalties from the IRS. Your financial institution will issue an amortization schedule, often detailing quarterly payments. If you fail to meet the quarterly payments, then the loan may become taxable income.
- If you have a remaining loan balance after five years, then your loan is considered a withdrawal from your retirement account. Unless you are 59 1/2 at that time, the IRS will slap a 10% early distribution tax on the remaining balance in addition to income taxes you'll have to pay on that amount, too.
- If you cannot pay back the loan, you will suffer a major retirement pitfall. Remember that there is a limit as to how much you can contribute to your retirement account each year. So, when that money leaves your nest egg, it never comes back.
One important tax benefit from borrowing from your 401(k) retirement account is that you can have your loan payments deducted from your taxable earnings. This effectively reduces your taxable income while you're paying off the loan.
2. You Don't Have Cheaper Forms of Credit Available
If your credit score is less than stellar, you may be having a hard time finding alternative sources of financing. Because you are borrowing from existing funds, the retirement loan application process is more streamlined and requires no credit checks. (See also: How to Rebuild Your Credit)
Shop around and check if you can find more favorable terms for your desired loan amount. Make sure to include additional loan costs, such as origination, administration, and maintenance fees. Ask your plan manager about all applicable fees for your loan. If you don't have access to a bank loan, there are still other ways for financing. Borrowing from your retirement account is a last resort, so make sure to carefully review your plan(s) and loan options.
Paying down high-interest debts and consolidating debts are often smart uses of retirement account loans. Let's imagine that you need $20,000 to pay off a high-interest credit card. Shop around and check if you can find more favorable terms for your desired $20,000 loan. If not, then your retirement account loan can be a good way to pay down your credit card debt. (See also: The Worst Ways to Pay Off Credit Card Debt)
3. You Need a Down Payment for a Home Purchase
A home is one of the most important assets that you will ever own. It not only allows you to put money to better use than paying rent, but also it builds equity over time. This is why using a retirement account loan for a down payment for a home purchase is a good idea. (See also: What to Know Before Buying Your First Home)
If you need $10,000 or less, have a traditional IRA, and plan to purchase your first home, then the IRS allows you to take a penalty-free early withdrawal of up to $10,000 from your traditional IRA. Keep in mind that if your spouse also has a traditional IRA, then your spouse can also make a penalty-free withdrawal of up to $10,000 from an IRA account. This way you can pull together up to $20,000 for a down payment on your first-time mortgage. (Note that this is taxable income.)
Also, you can make penalty-free withdrawals for the first time home purchase of a home for your children or grandchildren. An advantage of making the withdrawal is that you don't have to pay the money back. (But you still should.)
If you need more than $10,000 or don't have a traditional IRA, then you should look into borrowing from your 401(k) to make that down payment. As mentioned earlier, this type of loan can help you put together that down payment at a lower cost and lower your taxable income.
While it may seem tempting to dip into your retirement account for funds you need right now, consider all your options carefully before doing so. You may face hefty tax burdens if you can't pay it back in time, or your employment situation changes. You'll also be lowering the balance on your retirement account, losing compound interest and the extra time for growth. However, there are some scenarios where a loan from your nest egg can be a smart idea.
Have you ever borrowed from your 401(k) or other retirement account?