What You Need to Know Before Borrowing from Your Retirement Plan
March 30, 2015 | Your Finances
When you’re in need of cash, a loan from your qualified retirement plan might seem like a good option. In fact, from 2009 through 2013, about one in five people who were eligible to take loans from their 401(k) had taken one, according to the Employee Benefit Research Institute.
However, borrowing money from a tax-qualified employer retirement account like a 401(k) is complicated and can leave you on the hook for additional taxes and penalties. A lot of people who take loans wind up paying for it. In 2011, the Internal Revenue Service collected more than $5 billion in penalties from taxpayers who took premature withdrawals from their tax-deferred retirement accounts.
The Rules for Taking a Loan
“People generally aren’t aware of the problems and restrictions they face when borrowing against their qualified employer retirement plan,” according to Polina Engel, senior advanced planning attorney with Northwestern Mutual. In order to avoid taxes and penalties when taking a loan, you will need to adhere to strict requirements, including:
- Entering into a written, binding repayment agreement with the qualified plan provider. That agreement must include the terms of the loan, repayment schedule, and other conditions.
- Repaying the loan in substantially equal payments within a specified period, usually five years.
- Borrowing no more than you are allowed, typically not more than half of your vested balance (the amount of money that you actually own), not to exceed $50,000.
These requirements apply throughout the life of the loan. If you don’t meet them at any time a loan is outstanding, the entire loan is treated as a “deemed distribution,” or a permanent, premature withdrawal from your plan. That amount will be subject to income tax and a possible 10 percent penalty.
Even if you meet all of the necessary requirements, a change in your employment status can throw a wrench into your repayment plan. If you leave your job—either on your own or if you are let go—the employer is likely to require that the loan be repaid, generally within 60 days. As a recent decision by the United States Tax Court1 demonstrates, if an employee can’t or doesn’t repay a plan loan after leaving the employer, when the employer withholds money from the account to repay the loan, the employee is subject to both tax and potentially a 10 percent penalty on the amount withheld.
The burdens of repaying money borrowed from your qualified employer plan, compounded by the forced early repayment in the case of an unexpected change in employment status, are reasons enough to think very carefully before considering such a loan, according to Engel.
Perhaps the strongest reason to avoid the temptation is this: “You originally made a commitment to save for your future. Borrowing against your retirement plan creates a huge obstacle in this important lifetime endeavor,” Engel notes.
Before taking a loan from a retirement account, it’s a good idea to talk to your financial professional. He or she can help evaluate your options and determine whether a loan is the best course of action, considering your overall planning goals.