To Take a Loan or Not to Take a Loan…

If you are trying to decide whether you should borrow from your retirement plan savings or not, take first steps first. Check with your plan administrator or Benefits book to verify if your plan even allows you to take out a loan. Some plans do and some plans don't. If you find out your plan does allow loans, then you'll also need to find out about the rules around the loan feature. Then comes the difficult part — answering the question of whether or not to borrow from your plan.

Key Point to Remember: Don't Do It Unless You Have To
Of course, as with most financial planning issues, there are pros and cons. If you understand both sides, you can make solid decisions. Usually, if loans are allowed, you can borrow up to fifty percent of your account balance limited to $50,000. There may also be a minimum amount. The rate of interest you'll pay on the loan is based on your plan's rules. Generally you'll have up to five years to repay the loan unless it is used for the purchase of a primary residence where ten to fifteen years is common. Repayments of the principal and interest are automatically deducted from your paycheck.

So What Are the Advantages?
• Usually the rate of interest charged by the plan is a fixed rate for the period of the loan and is similar or lower than commercial lending rates. A formula of prime plus one or two is common.
• The interest you repay on the loan is paid back to your retirement plan account. So you are borrowing your retirement plan money and paying yourself the interest.
• Generally, the qualifying process is less onerous than with lending institutions. But typically on home loans, you are required to show escrow documents.

And What Are the Disadvantages?
• You are borrowing from your retirement plan account. That means your investments are sold to provide you with the cash. So the money you withdraw is no longer earning compound interest. Your account value may be much smaller at retirement depending on how much you take out and how long the loan period.
• If you leave your employer, you will need to repay your loan usually within ninety days. If you don't repay it, the loan will be in default and subject to regular federal, state and local income tax on the whole amount and a 10 percent penalty if you leave the employer prior to age 55.
• When you repay the loan, the deductions from your paychecks are after-tax. When you retire and take your money out of the account, any amounts you take out are subject to income tax. That means on the loan repayment amounts, both principal plus interest, will get taxed twice.

When Should You Take a Loan from Your Retirement Plan?
• When you have to due to a lack of other options or resources. You should first access other savings then try to get a loan from other sources (bank, credit union, school loans or mortgage company) before you resort to your retirement plan.
• If you have a planning strategy whereby you save more than necessary in your retirement plan in order to provide for other needs. Usually if you use this strategy you should be investing the loans proceeds in an investment or asset that you expect to go up in value at a rate higher than your retirement plan investments.
• The math to this can be somewhat complex, but let me give an easy example. A participant in the retirement plan is 22 years old and decides to save 20% of salary in the retirement plan even though the retirement goal could be met saving 10%. The expected return on the retirement plan investments is 12% annually. The participant wants to buy a home in five years. If the home appreciation and tax savings provides a return over 12% annually, the retirement plan loan may be the best planning tool.

Cautions:
• If you do decide to take a loan from your retirement plan, try your best to keep contributing to the plan. Your loan repayments are not new contributions and won't qualify for employer match.


• Try to pay off the loan as soon as possible.


• Be sure not to default on the loan. You may need to take the loan into consideration when deciding to leave your employer.

Disclaimer: The views represented above are those of the author, and the information provided here does not constitute any tax, investment or legal advice. The historical data presented are for illustrative purposes only. Past performance is no guarantee of future results.