By: Tina Schackman, CFA®, CFP®, Senior Retirement Plan Consultant
It’s important to note that not all retirement plans allow loans to be taken, so you should consult with your benefits department or contact your plan’s administrator before considering a loan from your employer-sponsored retirement account (i.e., 401k, 403b, etc.). Whether or not to take a loan from your employer-sponsored retirement account is a significant decision that comes with both potential advantages and drawbacks.
Advantages of a Loan
- Accessibility: If you have a financial emergency or immediate need for a large sum of money, a loan might be an accessible source of funds, especially if you have difficulty getting a loan elsewhere.
- No Credit Check: Your credit score isn’t a factor in obtaining a loan because you’re borrowing your own money.
- Potentially Lower Interest Rate: The interest rate on a loan may be lower than what you would pay on a personal loan or credit card debt.
- Repayment to Yourself: When you pay the interest on a loan, you’re paying it back into your retirement account, so you’re essentially paying the interest back to yourself.
Drawbacks of a Loan
- Opportunity Cost: When you take money out of your retirement account, that money is no longer invested in the market. Therefore, you could miss out on potential growth and compounding interest, which could impact your long-term retirement savings significantly.
- Double Taxation on Interest: While the money you borrow from your retirement account isn’t taxed when it’s taken out, the money you repay, including the interest, is done with after-tax dollars. When you retire and begin withdrawing from your retirement account, you’ll have to pay taxes again on those funds.
- Loan Repayment After Leaving Job: If you leave your job or are terminated (whether voluntarily or not), you’ll typically have to repay the entire loan within a short time, often 60 days. If you don’t, the remaining balance is considered a distribution and could be subject to income tax, plus a 10% early withdrawal penalty if you’re under age 59 ½.
- Possible Reduction in Retirement Contributions: If you’re paying back a loan, you might find it difficult to also continue contributing to your retirement account, especially if finances are tight. This could further reduce your retirement savings and impair your retirement goals.
In general, it’s often recommended to view an employer-sponsored retirement account loan as a last resort after considering other options, such as an emergency fund, budget adjustments, personal loans, or even home equity lines of credit. While a employer-sponsored retirement plan loan might make sense in certain situations, it’s crucial to understand the potential impact on your long-term financial health.
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