Borrowing At Your Own Risk?

November 9, 2011 - Mike S
A tough economy forces people to make difficult choices. When money is tight, some people might feel forced to choose between food and medicine. Another tough choice is saving for retirement or borrowing from your retirement account to pay for today’s necessities. 
With the 2010 Census Bureau reporting that the nation’s poverty rate had increased for the third consecutive year to 15.1 percent (that’s 46.2 million people!), it seems more common that people are being forced to make these difficult choices every day.
If you are faced with choosing between taking a loan from your 401 or 457 retirement account or falling behind financially, there are some important things to consider. 
  • You are borrowing your money at a cost. Unlike borrowing money from a financial institution, you are borrowing from yourself and paying yourself back. The principal and interest of each loan payment is applied directly to your retirement account. This money will purchase more shares in your investments and you will slowly begin to rebuild the savings you withdrew. The cautionary word here is “slowly.” The frequency of your payments is determined by your retirement plan features, as well as the type of payment you’ll make — either automatic withdrawals from your bank account or deductions from your paycheck. Unfortunately, the money you borrow is not invested and will not benefit from compounding — the ability of your invested assets to generate earnings on top of prior earnings. And there are tax consequences: the loan money may be taxed twice and penalties may be charged if the loan is not paid back as agreed.
  • Compounding allows your investments to grow over time. As your money remains invested in your retirement account, each additional contribution builds on the money you’ve already saved. Over the long term, the value of a well-diversified investment portfolio has the potential to grow. An article written by Stephen Moore, director of fiscal policy studies at the Cato Institute, referenced a study conducted by Tom Kelly, director of the Savers and Investors League. The study found that regardless of "the mutual fund's volatility over time, a fund's total return from any start year (i.e., 1930, 1950, 1970, etc.) to 1997, was virtually always 11% per annum."    
  • If you become unemployed, you may be required to pay the remaining balance of the loan in one lump sum. This could be an added financial burden especially if your unemployment was unexpected. If you do not pay the loan back, the IRS considers the withdrawal of money for your loan a taxable event. At the end of the year you will receive a 1099R form deeming the distribution an unqualified withdrawal from your account. If the loan was taken from your 401 plan, you may also be penalized 10 percent of the amount of the distribution.
A loan from your retirement account shouldn’t be your first option, but if it is your only option:
  • Be sure you are able to pay back the loan on time.
  • Only take out the amount you absolutely need.
  • Be sure to read and fully understand the terms of your loan.

If you change your mind about using a loan from your retirement account, you have a period of time after receiving the loan payment to rescind the loan and return the money to your account.

Most retirement plans will not allow you to take out another loan if you default on a prior loan. So, if your financial situation does not improve, a new loan may not be an option. Instead, consider ways to build an emergency fund (check out “The Emergency Fund: The Foundation of a Savings Portfolio” article on this site). AC: 1111-5254

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