8. 401(k) and Other Retirement Plan Loans
It sounds like a great deal: Borrow from your retirement fund and pay back yourself instead of a bank. You get a great interest rate, and the loan doesn’t show up on your credit report or affect your credit score.
Plenty of people take the bait. About one in four participants in large-company 401(k) plans had a loan outstanding, according to research firm Aon Hewitt. The average loan balance at the end of 2010 was $7,860, or 21% of these participants’ total plan assets.
But borrowing money from retirement plans is fraught with hazards—so many that most people should look elsewhere if they need funds. A loan or, worse yet, a withdrawal from a retirement fund typically should be a last resort, something you do only when you’ve run out of options.
In Chapter 2, “Your Debt Management Plan,” you read about why saving money for retirement needs to be a top priority for just about everyone. Employers increasingly have shifted the burden of paying for retirement to their workers, and Social Security’s future is uncertain.
The vast majority of workers should be looking for ways to boost what they save, rather than figuring out ways to tap their retirement funds early.
If you do decide to borrow from the money you’ll need for retirement, though, be sure to read this chapter carefully so that you know what precautions to take.
Types of Plans That Offer Loans
Right off the bat, you need to know that not all retirement funds allow loans. You can’t get a long-term loan from an individual retirement account (IRA) or a Roth IRA, for example. (You can take money out for up to 60 days, but if you don’t put it back, it’s considered an early withdrawal—which means you’ll pay taxes and penalties.)
By contrast, workplace plans like 401(k)s and 403(b)s aren’t required to allow loans, but most of them do. So do many 457 deferred compensation plans offered by government agencies.
There are some differences between these three major types of workplace plans, but all three allow workers to contribute pretax money, with their investments growing, tax-deferred, until they are withdrawn. The best-known type, the 401(k), usually is offered by a private employer, while 403(b)s are common at public schools and nonprofits. Deferred compensation or 457 plans may be offered by private employers, but they’re far more common at government agencies that want to allow their workers to put aside money in addition to whatever traditional pension their jobs offer.
Many employers decide to allow loans from their plans because they know some workers won’t sign up unless they can have ready access to their money. Even though loans might not be in the employees’ best interest, companies know that not signing up is the greater of two evils.
Here’s how the loans typically work:
• You can withdraw up to half your balance or $50,000, whichever is less. When figuring your balance for loan purposes, the plan looks at everything you’ve contributed, plus whatever employer contributions are vested. (Vesting means you can take that money with you if you leave your job; it’s typically keyed to how long you’ve been with the company. Most people are fully vested or can take all their employer contributions, plus their own contributions, when they leave a job after five or six years.)
• You’re required to pay back the loan over five years. Many plans allow you to take more time if the money is used to buy a house. Typically, the plan wants you to repay the money in equal installments—either that, or you can pay it all off in one lump sum. You typically can’t speed up the payoff just by adding money to each payment.
• You pay an interest rate that’s set by the plan. It may be relatively cheap and one or two percentage points higher than the prime rate. The prime rate is the benchmark used for all kinds of lending, from credit cards to home equity loans. Or the rate you pay on a 401(k) loan could be a higher fixed rate of 8% or 9%. Either way, these loans are overpriced. It’s your money to start with, and if you default on a 401(k) loan, neither the plan nor your employer is out any cash. You’re the only one who’ll be poorer because you’ll owe taxes and penalties on the unpaid balance. Plus you’ll lose out on those future tax-deferred returns.
The Real Cost of Retirement Plan Loans
Still, lots of people are attracted to retirement plan loans because of the low rate and the fact that you’re paying this interest to your own account. The latter feature is what leads many people to proclaim that 401(k) loans allow you to “pay yourself back.”
But are you really? Well, yes and no.
You are “paying yourself back” in the sense that you’re not paying interest to a bank. But if you hadn’t withdrawn the cash for the loan, that money would still be invested in something in your account, and that something probably would have been earning interest or other returns all on its own.
So instead of letting your investments earn returns, you have to dig those returns out of your own wallet.
Some of my readers have bragged to me that they were glad they took out 401(k) loans during the financial crisis, when stock prices slid sharply and many retirement plans suffered steep declines. At least, they said, the money they’d borrowed was earning a steady, positive return, even if it was coming out of their own pockets.
But you can’t know in advance how your investments will fare over the next five years. Many folks who borrowed against their 401(k)s when stocks were soaring more than 20% every year in the late 1990s kicked themselves for pulling money out of their investments to fund a loan.
Foregone returns on borrowed money aren’t the only hazard of retirement plan loans. Another real problem is how quickly an innocent little loan can turn into a big tax nightmare.
Most workplace retirement plans require you to pay back a loan pretty quickly, usually within 60 days, if you lose your job. If you can’t come up with the cash—and 70% of terminated 401(k) borrowers can’t or don’t—the loan becomes a withdrawal. And that’s not good.
Withdrawals are considered taxable events, which means you’ll owe income taxes on that unpaid balance. If you’re younger than 59½, you’ll also owe penalties for premature withdrawal (10% for the feds, plus whatever your state assesses). You could easily face a tax bill equal to one third to one half of the outstanding loan—just as your major source of income has been shut off.
Here’s an example. Suppose Joe gets laid off owing $10,000 to his 401(k) plan. Because he’s in the 25% federal tax bracket, he’ll owe $2,500 in federal income taxes plus another $800 or so in state income taxes (he lives in California, where income taxes range up to 12.3%). The feds will want another $1,000 as a penalty for the early withdrawal, and California will take $250. His $10,000 balance will trigger a $4,550 tax bill.
Something similar can happen if you miss even one payment on your retirement plan loan. Skipped payments can trigger a default, and your unpaid balance is treated as a withdrawal.
The potential tax bill, bad as it is, is not the only thing you need to worry about. After you have withdrawn money from a workplace retirement plan, you can’t put it back. The $10,000 you withdraw now could have grown to $49,268 in 20 years, $109,357 in 30 years, or an amazing $242,734 in 40 years, assuming an 8% average annual return. So each $1 you withdraw at age 35 could cost you about $24 when you’re 75.
Your money can grow thanks to the power of compounding—your returns earning returns of their own. You don’t want to mess with that if you can possibly help it.
There are some exceptions to the rule that a job loss means an instant loan payback. Aon Hewitt found that one in five large company plans allowed former employees to continue making payments on their 401(k) loans. If yours is one such company, the risks of a 401(k) loan are lessened. (If you don’t have a new job to replace the one you lost, that may be tough, but at least it’s easier than trying to come up with a lump sum.)
You need to consider one other issue before taking out a retirement plan loan. Is it possible that this borrowing will be a crutch to help you continue overspending? As with home equity borrowing, a retirement plan’s low rate and easy terms can lead people to think they’ve “solved” their high-rate debt, when all they’ve really done is covered up the problem.
If you pull money out of your retirement plan to pay off your credit cards, and then you run up more credit card debt, you haven’t solved anything. In fact, you’ve made matters worse. You’ve put your retirement at risk to pay for meals, clothes, and movies long since forgotten. You haven’t figured out how to live within your means, which means you’ll probably be facing another debt crisis in the not-too-distant future.
Besides, credit card debt generally is something you should be paying out of your current income. Stretching it out over five years might actually increase the debt’s total cost. You may find that if you take another look at your spending, you can carve enough money out of your budget to pay off the debt much faster and without the potential disadvantages of a retirement plan loan.
If you’ve considered all this and you still want to go ahead, take the following steps:
• Fix the leaks. If you’re using the money to pay off past over-spending, make sure you create—and stick to—a spending plan that prevents you from going into further debt. For the time being, at least, put away your credit cards and live on cash.
• Check your plan’s repayment policies. You’ll want to know if your loan will be called in if you lose your job or if you’ll have some time to pay it off.
• Have a Plan B. If your company demands loan repayment when you leave your job, make sure you have some other source of cash you can tap to pay it off. Keep plenty of open space on a home equity line of credit or your credit cards, for example—enough to pay off the loan and to provide your living expenses for the several months you may need to find your next job.
• Pull the money from your fixed-income investments. If you have a choice, ask that the money for your loan be taken from your bond, cash, or other fixed-income investments, rather than from the stock side of your retirement plan portfolio. You don’t want to miss out on the potentially higher returns that stocks can offer.
Cracking Your Nest Egg Early
If your goal is to withdraw money from your retirement plan rather than borrow it, you’ll probably discover that there are several ways to crack open your nest egg.
Many 401(k)s and other workplace retirement plans allow hardship withdrawals for certain purposes: to buy a home, to prevent eviction or foreclosure, to pay medical bills, or to cover the cost of college tuition for the next year. (Your plan may allow withdrawals for other reasons, but you generally have to prove that your financial need is substantial and pressing and that you have no other resources to tap.)
Hardship withdrawals don’t come cheap. They incur income taxes and can incur penalties just like any other premature withdrawal.
You can avoid the penalties if any of the following are true:
• You’re 59 1/2 or older.
• You’re 55 or older and are “separated from service,” meaning that you’ve quit, retired, or been fired or laid off.
• You’re “separated from service” and you’ve set up a series of regular payments based on your life expectancy. (These scheduled withdrawals, known as “substantially equal periodic payments,” must continue for at least five years or until you’re 59 1/2, whichever is later.)
• You’re totally and permanently disabled.
• The withdrawal is required by a court order to give the money to an ex-spouse, child, or other dependent.
• Your medical expenses exceed 7.5% of your adjusted gross income.
The situation is much the same with a traditional IRA, although you don’t have to say why you want to access your funds. You simply write a check or get the brokerage or bank holding your account to send you the money.
Again, you’ll owe income taxes on the withdrawal, but you can avoid penalties in certain cases. Setting up the periodic payments just described is one way, although you don’t need to be “separated from service” to do so. Also withdrawals of up to $10,000 aren’t penalized if it’s for the purchase of your first home (although you’ll still owe income taxes).
If you’re taking money out of a Roth IRA, you won’t owe taxes or penalties unless the amount you’re withdrawing exceeds all your previous contributions. (Any withdrawal from a Roth is presumed to be a return of those original contributions; it’s not until you withdraw earnings that tax consequences are triggered.)
Just because it’s possible to take money from a retirement plan doesn’t mean it’s a smart idea, however. In fact, it’s usually the opposite.
The Hidden Cost of Withdrawals
Jim had major credit card bills—and a big IRA balance “that’s just sitting there. Wouldn’t it make sense to pull that money out and use it to get debt-free?”
John lost his job, and his company mailed him a check for his 401(k) balance. “I know this money is for retirement,” he said, “but I need it now.”
Wendy had a great idea for a business, but she couldn’t convince any of the area banks to give her a loan to get started. She was convinced if she used her retirement money, the success of her future enterprise would allow her to more than replace what she took.
All these folks thought they had good reasons to raid their retirement funds. And they’re all wrong.
The taxes, penalties, and lost future income I described earlier should be enough to dissuade anyone from tapping his or her retirement funds early.
But you also should realize that creditors can’t touch the money in most retirement plans. It’s safe in a way that other savings and assets are not. If worse comes to worst and you need to file bankruptcy, the money in your retirement plans usually can be preserved so that you don’t end up impoverished in your old age.
All three of the people I described are at heightened risk of going broke. Jim’s big credit card balances, John’s lack of a job, and Wendy’s plans to launch a business all increase their chances of financial failure, which makes it all the more important that they leave their retirement money alone.
Besides, they—and you—almost certainly have other, better options. Jim, for example, could trim his spending or get a second job to pay off his cards. John could make ends meet by getting a roommate or temporarily settling for a job that pays less. Wendy might be able to get a well-off friend to invest in her idea or get starting funds by (prudently!) tapping her credit cards.
Whatever your reason for wanting to crack open your nest egg, it’s probably not good enough. Retirement money should be left alone for retirement except in the direst emergencies.
One of the most heartrending letters I’ve received in recent years came from an older couple who drained their retirement funds (and their home equity) to pay huge medical bills. They believed they should pay their own way, but the health costs proved too much for them, and they were facing bankruptcy.
What they hadn’t realized is that they probably could have wiped out their medical bills in bankruptcy years earlier and spared their nest egg, which would have been protected from their creditors. Instead, they were facing a pretty dismal retirement with little but their Social Security checks to get them through.
Most of us feel a moral obligation to pay our bills. But sometimes life has other plans. The bankruptcy laws are set up to give people with impossible debts a fresh start. Retirement plans are protected because the government has an interest in making sure we’re not impoverished in our old age.
Another move that can be fraught with peril is raiding your retirement fund to avoid foreclosure. Yes, it may help you make the payments for a while, but it also can lull you into hanging on to a house that may no longer be affordable. Sometimes it’s better to sell a house rather than struggle to hold onto it; in that way you can avoid foreclosure while keeping your retirement money intact.
But what if you just want some cash for a house down payment? Or you want to retire early? Then it’s okay, right?
Not necessarily. You’re still giving up all those future tax-deferred gains that, if left alone, could ultimately make you a lot richer. Again, there are usually other ways to go.
In the case of a house down payment, you can get an FHA loan with as little as 3.5% down. There are programs that will grant or gift down payments to certain homeowners.
When it comes to retirement, most financial planners recommend that you avoid touching your tax-deferred money for as long as possible. The typical advice is that you live off other assets until you’re forced to start taking withdrawals from workplace retirement plans and traditional IRAs at age 70½. That gives your money the maximum time to grow.
Frankly, you’re at far more financial risk when you take funds early. With less money you have less wiggle room, and any downturn in your investments or unexpected expenses can be a disaster.
During bear markets, some early retirees who had set up substantially equal periodic payments were caught in the awkward position of not having enough cash left in their IRAs to finish out their five-year withdrawal plans, let alone pay for the rest of their retirement. You don’t want to get caught in that trap.
If you do decide to tap your retirement funds early, at the very least do the following:
• Have a tax pro review your plans. Some of the rules for these early withdrawals can be tricky.
• If you’re retiring, meet with an objective, fee-only financial advisor to discuss your plans, your investment allocations, your withdrawal schedule, and how you’ll pay for certain expenses, like health insurance. Try to start these discussions well in advance of your final day at work. Decisions about many aspects of retirement are irrevocable. You don’t want to find out after the fact that you’ve messed up and nothing can be done.
Summary
Borrowing money from retirement plans is fraught with so many hazards that most people should look elsewhere if they need funds. Those who do borrow money should take care that their loan doesn’t turn into an inadvertent withdrawal.
Credit Limits
• Loans generally are limited to half of your balance or $50,000, whichever is less. They typically are repaid over five years at an interest rate slightly above the prime rate.
• A missed payment or a job layoff can turn the loan into a withdrawal, triggering income taxes and penalties.
• Money withdrawn from a retirement plan can’t be returned, which means that every $1 you take out could potentially cost you $20 or more in lost retirement income.
Shopping Tips
• If you decide to take out a loan, fix your budget so that you’re living within your means and can make the payments.
• Check with your employer about how loans are treated should you quit or lose your job; if the loan would become due, make sure you have some other source of cash to tap to pay it back.
• Ask your employer to pull the loan proceeds from the fixed-income side of your portfolio to limit the potential impact on your returns.