Can I Take A Loan From My Retirement Account?
If you need access to cash, taking a loan from your retirement account may be an option that avoids the taxes and penalties that would apply if you distributed money from your account instead. However, there are some pitfalls to this strategy if you are not careful.
What Accounts Can Be Borrowed From?
For starters, you cannot take a loan against an IRA. This applies to individual Traditional and Roth accounts, as well as employer-provided SEP and SIMPLE accounts. Other employer retirement plans, like 401K, 403B, and 457 accounts can be established with rules that allow for loans. However, although the IRS permits employers to offer loans, it does not require them to do so. You will need to check with your company’s plan administrator to determine if loans are an option for your retirement account.
How Much Can I Borrow?
Loans made from a company retirement plan account are limited to 50% of your balance up to a maximum of $50,000, whichever is less. This is the limit within a 12-month period, but additional amounts can be borrowed after this period ends, assuming you have paid back a portion of your outstanding loan. The CARES Act of 2020 temporarily permitted loans of up to $100K or 100% of the account, which ever was less, but this provision expired in September 2020.
How Does Borrowing From My Retirement Account Work?
When you take out a loan from your retirement plan, the investments you hold in your account are sold and converted to cash in the amount of your loan request. Trades in a retirement account typically take 2-3 business days to settle. Once the cash is available, the money can be distributed to you. Loan terms vary by employer but according to FINRA, the longest term permitted under law is 5 years. The mechanism for paying back the loan is usually a payroll deduction. While you have an outstanding balance, an interest charge is assessed to you but it is paid into your account. The interest rate is based on current market rates offered by lenders for similar personal loan amounts.
Why Might This Be Better Than Simply Taking A Withdrawal?
Withdrawals from traditional retirement plans are subject to ordinary income taxes and the IRS stipulates that all distributions from such accounts be subject to a mandatory 20% withholding for tax purposes. This amount is remitted to the IRS on your behalf to cover any potential federal tax liability you might owe later. If you are under age 59½, a distribution from the plan may also be subject to a 10% tax penalty unless you meet certain conditions. Loans, by comparison, are not considered distributions, so no income tax or penalties are due.
A Strategy for the Self-Employed
If you’re starting a business and all of your money is tied up in retirement accounts, an option for accessing some of it may be to set-up a Solo 401K for yourself. Doing this will make it possible to roll over money from your other retirement accounts into the 401K plan you establish. Once the contributions are made, you can borrow from the account the same way you would have been eligible to do so at your former employer. This is an effective way to access capital or to fund a major purchase if you are just starting out.
What Are The Pitfalls?
First, the money you borrow from your account is money that is no longer invested. Sure, you are required to pay yourself back the amount you borrow plus interest, but the interest you pay back into your account is usually pretty modest compared to the returns you are likely to achieve by remaining invested.
Second, if you have an outstanding loan on your retirement account, employers typically don’t allow you to make additional contributions. Instead, your contributions are applied to the loan balance.
Finally, and most significant, if you separate from your employer, the outstanding loan amount comes due immediately. This is true whether it was your choice to leave or your employer’s. Your plan documents will outline how long you have until the loan is considered in default, but the amount of time you are given to pay it back is typically 90 days or less. If you are unable to pay off the loan, the outstanding balance is considered a distribution, which triggers tax consequences and a potential 10% tax penalty if you are under age 59½. If you are contemplating leaving your employer, this is one of the most significant things to consider before changing jobs.
Borrowing against your retirement account can help you avoid taxes and penalties, but it creates risk and can negatively impact the growth of your account, putting your retirement in jeopardy. If you are considering borrowing against your retirement plan, a comprehensive review of your financial situation might help you determine if this is your best choice or whether there are alternatives solutions you have not considered. If you are interested in learning more about how a financial plan can benefit you, please contact us today.