You're driving on the highway and you notice your vehicle is starting to smoke.
After being towed to your mechanic, you learn you're having major engine issues—and checking your bank balance is depressing. On top of all that, you just found out you owe the IRS. What do you do?
One option may be to borrow funds from your 401(k) plan. But before you do, there are a few things you should consider, ensuring you're making an informed decision.
A 401(k) plan is an employee-sponsored retirement plan that allows you to save and invest in your retirement—not to be confused with a savings account. In most cases, the money is deposited tax-free and you pay taxes when you withdraw the funds. Some plans allow for Roth contributions, where the money is taxed when it goes in, but then when you withdraw the funds at retirement, you don't pay taxes on your withdraw, including any earnings.
Other plans allow you to borrow money that is in your account, but not all plans do. Here are some common rules:
- Plans don't have to allow loans. Some set certain conditions, such as financial hardships only.
- The maximum amount you can borrow is 50 percent of your account to a maximum of $50,000 in outstanding loan balances in a 12-month period.
- The minimum loan is usually $1,000—meaning that you would need a balance greater than $2,000 to even take a loan.
As with everything, there are pros and cons. Let's look at a few:
- Most times, it is a relatively quick process since there is no credit check.
- Easy repayments since they are deducted from your paycheck.
- Interest is relatively low, usually 1 to 2 percent above prime.
- You are paying yourself the interest, not a bank.
- The loan repayments are taxed twice: when they are deducted from your paycheck and when you withdraw the money at retirement.
- You are missing out on the market earnings the money would have earned if you didn't take the loan.
- Money in qualified plans is protected in bankruptcy. If you're in really bad financial shape and take a loan to pay your creditors and end up filing for bankruptcy, you just reduced a portion of your assets that would have been protected.
- If you are reducing your contributions to cover the loan payments, you are saving less for retirement.
- If you have an outstanding loan and you leave your job, you either have to pay the loan back in full or it is taxable to you and you will potentially have to pay a penalty.
Most financial experts would say that the cons outweigh the pros. But there could be some good reasons for withdrawing early, such as borrowing for a down payment on a home or starting your own business. Ultimately, the decision is yours. Act wisely! This is your retirement money, after all.
Chad Rick, Senior Manager, Rehmann, develops creative strategies that help clients work toward success, integrating retirement plan objectives with overall business goals. He works with a cross-functional Rehmann team to proactively guide each client, leveraging plan design, administration and investment resources.