Borrowing from your retirement plan can provide you money when you need it most. There are no credit requirements since you are borrowing from yourself. The loan isn't reported to the credit bureaus, so if you are using the funds to purchase a home, it won't affect your debt to income ratio. Be wary, though: Tapping into your retirement account may appear less costly than other loans or credit cards, but it can cost you more than the interest rate if any of a variety of possible snags arise.
The Rules on Retirement Plan Loans
In general, you can only borrow against an employer-generated plan such as a 401(k) or a 403(b). You cannot borrow money from an IRA, and you can only borrow from your employer-generated plan if the individual plan's rules allow for it. The IRS will allow loans of up to $50,000 or 50 percent of your account's value, whichever is lower. In most cases, you must pay your loan back within five years, or the IRS will consider it a withdrawal and will sock you with a 10 percent penalty on anything you have not repaid. The lone exception: If you haven't owned a house for two years, you can borrow up to $10,000 and repay it over a longer term. If loans are allowed in your plan, the interest rate will be set by the plan administrator. Laws require the rate to be reasonable. Plan loans often charge competitive rates, much lower than credit cards and unsecured loans. Generally, the interest rate is the prime rate plus 1 or 2 percentage points. Unlike other loans that require you to pay interest to the lender, you pay the interest back to yourself. The entire loan payment you make is deposited back into your retirement account.
Lost Contributions and Earnings
Most plans will prohibit you from contributing more to your retirement plan as long as you have an outstanding loan balance against it. Cutting contributions results in less money for your retirement. Although you are paying interest back on the loan, you are losing the compounded interest you would earn on the funds you borrowed. For example, if you borrow money from your plan at a rate of five percent interest and the money you borrowed would have earned 15 percent if you had left it inside the plan, the real cost of your loan to your plan is 10 percent (its lost gains minus the interest rate you are paying it.) And, of course, your personal losses are much higher, since you not only have to pay the 5 percent interest out of your own pocket, you will lose the 15 percent that your money could have made.
Another cost you face is double taxation. Contributions to a 401(k) are made with pre-tax dollars, and you do not pay taxes on retirement contributions until you withdraw money from the plan at retirement. However, the money you use to repay the loan is taxed before you make your loan payment. When you begin taking qualified withdrawals, you will pay taxes again on the amount of the distribution -- even on the funds you repaid and the interest.
If you leave your job, voluntarily or involuntarily, the entire balance of the loan typically becomes due within 60 days. Without a job, paying back the loan may become impossible. If you can't repay the loan, the IRS will view the unpaid loan balance as a distribution. You will face taxes on the earnings and a possible IRS 10 percent tax penalty if you are under age 59 1/2.
Jeannine Mancini, a Florida native, has been writing business and personal finance articles since 2003. Her articles have been published in the Florida Today and Orlando Sentinel. She earned a Bachelor of Science in Interdisciplinary Studies from the University of Central Florida.