Understanding Plan Loans

Key Takeaway

Challenging economic times spur many retirement plan participants to consider borrowing from their retirement plan. Before you do, research the pros and cons, some of which may surprise you. Employer sponsored plans provide a convenient and effective way to fund your retirement. Don’t shortchange your golden years by treating it like a checking account.

Disadvantages

  • Loan Defaults
    Most plans require immediate repayment of loans if you leave your job. If you do not repay the loan, it falls into default. Defaulted loans are treated like withdrawals and included as part of your income for that year. You will be taxed on the unpaid portion of the loan at your current tax bracket in the year of withdrawal, and if you are under age 59½ an additional 10% IRS penalty will apply.
  • Opportunity Cost
    According to the U.S. General Accounting Office, the interest rate charged for a 401(k) loan is often less than the rate the plan funds would otherwise have earned if they had remained invested.
  • Tax on Repayments
    While most contributions you defer into your account are not taxed immediately, the payments on your loan are taxed as ordinary income.
  • Smaller Contributions
    You may feel tempted to reduce your deferrals to make your loan payments and thus reduce your future retirement plan balance. You may also miss out on receiving your full company match, if your plan has one, because of your reduced deferrals.
  • Loss of Safety Net
    If you borrow for a vacation or to pay off higher interest consumer loans you may diminish the amount available for you to borrow in a real financial crisis.

Advantages

  • Convenience
    There is typically no credit check for taking a loan from your account and your loan may not need to be secured by something of appraised value.
  • Low Interest Rate
    Depending on the terms of your document and your credit rating, the interest rate on the loan you withdraw from your retirement account may be much lower than the rate you would qualify for commercially.
  • Repayment to Yourself
    While you will pay interest on your loan, it will be repaid to you.

Summary

Before you apply for a loan from your account, consider the pros and cons of your decision. In some cases a loan from your retirement account truly is the best option, but be aware of the consequences.