Borrowing from your retirement account might seem like an easy way out of a financial pinch. After all, you are just borrowing from yourself, right? While this may be true, retirement borrowing can disrupt the advantages of your plan and in some cases jeopardize your future financial security. There is more to retirement borrowing than meets the eye, and further consideration is warranted before dipping into your retirement savings.
The basics:
Many employer-sponsored retirement plans allow employees to borrow funds from their retirement accounts in case of a financial emergency.
- When an employee borrows from their retirement account, those funds are liquidated from the retirement account and “loaned” out to the employee.
- The employee must pay those funds back to their account with interest (usually around 5 – 7%) over a term of five years.
The pros:
- There is no credit requirement (since you are technically borrowing from yourself) so your rates and terms will not be affected by your credit profile.
- As long as you cover the payments on time and don’t incur any penalties, the interest will be paid back into your own account.
However, there are significant costs to borrowing from your retirement account, even if the interest is ultimately paid to yourself. The costs of retirement borrowing are primarily caused by tax consequences and missed growth opportunities.
Tax costs:
Most retirement plans (including 401k’s and 403b’s) are funded with pre-tax dollars. Earned wages are contributed directly into your retirement account—unfettered by Uncle Sam—to be taxed later when you eventually withdraw your funds in retirement. This is important because you will usually be taxed at a lower rate in retirement than while you are working.
- When you borrow pre-tax dollars from your retirement account, you have to pay that money back with dollars that have already been taxed (presumably at a higher rate than what you would pay if you left the funds alone until retirement). Therefore, you miss out on the tax breaks your retirement plan is designed to provide.
- The interest you pay to yourself will also be taxed again when you withdraw your funds in retirement. The interest may be relatively small, but no one enjoys paying taxes—much less paying them twice.
What if you can’t pay make the payments?
If you can’t make the required payments on time, the loan may go into default and the IRS will consider the withdrawal of your retirement funds to be a taxable distribution.
- This means you will likely have to pay full income taxes on the borrowed funds at your current tax rate.
- If you are under the age of 59 and a half, a 10% early withdrawal penalty will also be applied!
What if you leave your job with a loan outstanding?
If you leave your job for any reason while you have a retirement loan outstanding, you will be required to repay the entire balance of the loan much earlier than the original five-year term.
- The current standard deadline to repay the entire loan is the due date of your federal income taxes for the year you left your job.
- If you are not able to repay on time, the loan will be considered a taxable distribution and income taxes (as well as early withdrawal penalties) will apply.
Missed growth opportunities:
In addition to potential tax consequences, retirement borrowing can be costly when it causes an employee to miss out on the growth of their account.
- Retirement accounts benefit from investment growth. When you borrow from your account, you miss out on the tax-protected investment growth of those funds.
- For reference, the average annualized return of the S&P 500 stock market index is roughly 8% since it began tracking 500 stocks in 1957.
Many retirement plans also feature employer matching contributions, where your employer will match a percentage of the contributions you make to your account—often up to 50% or even 100%!
- When you have a retirement loan outstanding, you may be ineligible for employer matching contributions because you are not considered to be contributing to your account during this time. Missing out on automatic 50% – 100% growth of your contributions is a huge cost!
On principle:
Retirement plans are designed to hold your funds in a tax-protected, growth-friendly account to set yourself up for comfortable living when you eventually withdraw your funds in retirement. Borrowing from your retirement account can disrupt the advantages that your plan is designed to provide, and in the worst-case scenarios can jeopardize the nest-egg that is intended to support you through retirement.
Consider your options:
When facing a financial emergency, it is important to consider all your options before taking action that may jeopardize your financial future. Many employees borrow from their retirement accounts due to lack of viable alternatives—remember, one of the “pros” of retirement borrowing is that there is no credit score required.
The VIVA alternative:
VIVA’s employee loans are designed to provide a source of affordable financing for individuals who may have limited options due to damaged credit history. Through VIVA’s program, employees can access personal loans up to $10,000 with rates beginning at 12.20% APR. VIVA’s employee loans can be used as an alternative to retirement borrowing to help employees protect their savings and future financial security. Eligibility with VIVA is based on employment, and there is no collateral or minimum credit score required.
Eligible employees can apply for free at www.viva-finance.com to see if there is an offer that is right for their financial needs. If you have any questions, please give us a call at (678) 685-8834 and a team member will be happy to speak with you.
Thank you for being part of the VIVA Finance community and we look forward to serving your financial well-being!
Sincerely,
The VIVA Team
All loans subject to the credit underwriting policies of Viva Finance Inc.
VIVA’s loans are not provided by, sponsored, or endorsed by any employer. VIVA Finance is an optional resource and employers in no way benefit from VIVA’s loans. VIVA Finance is not directly affiliated with any employers and completely releases employers from any liability.
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