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I Need Money! Should I Borrow from my Retirement Plan?

balancingWe’ve been talking about money decisions in tough times and how it may affect your 401(k). We started by looking at cashing out a 401(k), which is the absolute last resort.

Next, we looked at cutting back on 401(k) contributions. This is a much better option than cashing out, but you should try to contribute up to the limit of your employer’s matching contribution. That’s found money so you’ll be thankful you did.

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Now, we want to look at borrowing from your 401(k). The best advice we can give you on this is … don’t listen to us! Seriously, we can only talk about this in a general sense. So before you make a decision, talk with your professional financial advisor about the specifics of your situation. Then you can do what’s best for you with confidence.

There may be a better solution

Before you borrow from your 401(k), consider whether a home equity line-of-credit might be a better solution. You may already have one you can tap into. If not, consider applying for this type of loan instead of borrowing from your 401(k).

These loans are not as easy to get as they were a couple of years ago. You also won’t get as much of a line as you might have then because house values in many areas.

How much can you borrow?

If you decide a home equity line-of-credit isn’t your best bet, you can tap your 401(k) up to two times each year for money. It’s your money, so there’s you don’t need to be approved for the loan. You can borrow up to half of the vested portion of your portfolio, with a $50,000 limit.

Pay back is purgatory!

A loan from your 401(k) is a relatively inexpensive source of money. However, you’ll be paying the loan back with after-tax dollars (i.e the interest isn’t deductible). Compare that to a home equity line-of-credit, which is deductible in most cases.

In the eyes of the government, you and your 401(k) are two separate “entities”. So even though you think you’re borrowing from yourself, you’re not – you’re borrowing from your 401(k) so you have to pay it back within five years with an exception for first time homeowners who may have a longer payback term.

You can do that with each paycheck or you can do it in installments. You have to make a payment at least once every quarter. For example, if you borrowed $10,000, you would have 20 quarters to pay back the loan so you would have to pay $500 every quarter plus interest.

Of course, while you’re paying back the loan, you’ll have less money to spend every paycheck or every quarter, depending on which way you choose to pay back the loan. If things are tight now, what will they be like with even less free cash flow?

The other thing to consider about paying back your loan is that the dollars that were taken out of your portfolio are only earning whatever interest rate you’re paying. If that rate is less than what you could have earned if you kept it invested in your portfolio, you’re losing money you would have had at retirement.

No pay back is hell!

So it may be tempting to “borrow” the money and then not pay it back. In the government’s eyes, that’s the same as cashing out. So you’ll have to pay income taxes and, if you’re under 59½, you’ll also pay a 10 percent penalty. 

Analyzing the scenarios

The Center for American Progress Action Fund recently analyzed a number of scenarios [pdf]. Let’s look at the two extremes:

IF you take out a loan, pay it back with interest, and continue making your regular contributions, THEN there is almost no effect on your expected portfolio at retirement. In fact, in all the scenarios they considered under these conditions, there is less than a one percent difference in the end portfolio. Not so bad, huh?

But that ignores the fact that we’re borrowing money because we need it now. So we’re likely to cut back on our 401(k), if not stop making contributions altogether. That’s the double whammy.

IF you do that (i.e. the double whammy), THEN you can expect your savings at retirement to be as much as 22 percent less. 

What if …

Before you borrow, ask yourself some questions. For example, what if your company cuts back and you lose your job? Let’s spin it in a positive direction, what if you get a great job offer? You want to consider these scenarios as well before deciding if you want to borrow now.

Bottom line

Look for other ways to cut back on your spending. Even a little bit here and there can make a bigg difference. Consider temporarily cutting back on your contributions, but don’t dip below your employer’s match if you can possibly avoid it. Borrow if you must, but don’t cash out unless there is just no other alternative.

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(Image by srbichara)