Should You Borrow from Your Retirement Account to Pay Debts?

This article was written by Stacy Johnson and originally appeared on MoneyTalk News October 21, 2014.

Nobody wants debt hanging over their head, especially the high-interest kind. Among the options available to destroy it, doesn’t it make sense to borrow from yourself?

Can you borrow from your retirement plan?

The law allows loans from common qualified retirement plans, like 401(k)s and their nonprofit cousins, 403(b)s. But while the law allows loans, plans aren’t required to offer them. So first see if your plan allows loans, and if so, what kind. For example, some plans only allow hardship loans, meaning you’ll have to be in dire straits, like facing eviction, to qualify. Others allow you to borrow for any reason.

The most you can borrow from most qualified retirement plans is the lesser of $50,000 or 50 percent of your vested balance, although some plans have an exception that allows loans of up to $10,000 even if 50 percent of the vested balance is less than $10,000.

The longest you can take to pay the loan back is five years, longer if the loan is to finance a house.

You’ll pay interest at the rate established by the plan. But the interest you pay goes into your account, so you’re paying it to yourself. Doesn’t that beat borrowing from a bank, or paying 20 percent on a credit card?

You’d think so, but let’s go over the drawbacks.

Why borrowing from retirement accounts is bad

1. You’re putting the brakes on your savings. Many retirement plans prohibit making additional contributions to your account until the loan is repaid. So when you borrow, you’re not building your retirement savings. And even if you can continue contributing, can you afford to do that and make payments at the same time?
2. You’re not making as much. Sure, you’re paying interest to yourself on the amount you borrowed. But that interest may not be as much as the returns you could have achieved in stock mutual funds or other investments in your account. You’re obviously also not making money on the money you could have contributed, but now can’t.
3. You’re repaying the loan with after-tax money. When you make regular contributions to your retirement account, those contributions aren’t taxed. But when you pay back your loan, the income you’re using is after-tax. For example, if you’re in the 25 percent bracket, you’ll have to make $100 to pay $75 of your loan. And the interest you pay isn’t tax-deductible.
4. Better be able to pay it back. Should anything arise that prevents timely repayment of the loan, it can become a withdrawal, subject to income taxes and a 10 percent penalty.
5. Better love your job. If you lose your job, you’ll have to pay the money back quickly, typically within 60 days. Otherwise, as above, you’ll be both taxed and penalized.
6. There could be a loan origination fee. Ask your employer.

When borrowing from retirement accounts makes sense

You’d think after reading the above that nobody should ever borrow against a retirement plan. Yet, it’s common. Here are some examples of when they might be appropriate:

• When you have no other choice. If your back is against the wall and you have no other options, the decision is easy.
• When it’s the best you can do. If you really need money, these loans may be the least expensive way to get it, in terms of interest, fees and convenience.
• When the math works out. If you’re paying 21 percent on a credit card and repay your retirement account at 5 percent, you’re obviously money ahead by borrowing. And this can be especially true if …
• Your investments are about to crash. When you take money out of your retirement plan, it’s obviously no longer available to earn anything in whatever investments you’ve selected. The more the market takes off after you remove the money, the higher your opportunity cost. But if it crashes, you were certainly better off using the money to pay off a 21 percent credit card than watching your balance crater. If your investments have doubled over the last several years, this is a backdoor way of locking in some profits.

What should you do?

The first question you should ask yourself is “Why are you in debt in the first place?” If you have debt because you’re regularly spending more than you’re making, all you’re doing is kicking the can down the road. While some options may prolong the agony more than others, in the end you’re in the same place: bankruptcy court.

If, however, the debt you’re dealing with arose because of a temporary and now resolved situation, such as an illness or job loss, great. The less interest you pay, the sooner you’ll recover.

If you are having trouble making ends meet, seek help from a qualified credit counselor. If you simply has some high-interest debt you’d like to pay off, and can keep it paid off when you’re done, a loan from your retirement plan could work, especially if you  can continue making regular contributions in addition to the loan payments.

But you need to realize that the less you fiddle with your retirement nest egg, the better. Retirement plans aren’t piggy banks. They’re how you’re going to stay alive and enjoy life when you’re no longer able to work.

Submitted by Kathryn Shrader