In times of financial difficulty, it is tempting to turn to just any source of funds. According to Time, 25% of workers with a defined contribution plan have tapped their retirement accounts. The article also points out that the amount of money being taken out of retirement accounts reached $70 billion in 2010.
That’s a lot of money.
Many workers decide to borrow money from their retirement accounts because borrowing the money from themselves seems like a better solution than borrowing from a bank. However, it’s also important to be aware of the drawbacks associated with borrowing from your retirement account.
Advantages of Borrowing from a Retirement Account
The main advantage of borrowing from a retirement account is that you are borrowing from yourself. You still have to pay interest as you repay the loan, but the interest you pay goes back into your retirement account, instead of being paid to a bank.
Another advantage is that you have relatively easy access to the funds. As long as you meet certain requirements, and your employer allows retirement account loans, it’s possible for you to access your nest egg. That’s often most workers’ largest source of relatively liquid assets.
Since the money is a loan, it’s not considered an early withdrawal, and you avoid the 10% penalty if you are under 59 ½, and you don’t have to report the amount withdrawn as income.
Disadvantages of Borrowing from Your Retirement Account
Of course, there are disadvantages to borrowing from your retirement account. First of all, when you borrow, you usually have to pay an origination fee — and that doesn’t go back into your account.
The biggest disadvantage to borrowing from your retirement account, though, is the opportunity cost. It’s true that you are paying interest to yourself, and returning your principal, plus the interest, to your retirement account. However, there is no making up for the time that your capital was no longer working for you. Depending on market performance, you might be missing out on better gains because you pulled your capital out of your account, and it was no longer earning a return.
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Another consideration is the repayment issue. Many 401(k) loans have terms of between three and five years. (Roth IRA loans have different rules.) However, things change abruptly when you leave your job, or if you are laid off. When you no longer work for your employer, your 401(k) loan becomes due almost immediately, usually within 60 to 90 days.
If you don’t repay the loan within the specified time period, the loan is considered an early withdrawal. This means you pay the applicable penalties and taxes. But, if you can’t afford to repay the whole loan so quickly, paying the penalty and the tax might be a more manageable option, especially if you have a few minutes to recover a little bit and save up to meet your tax obligation.
Should You Do It?
In the end, it’s up to you whether or not you decide to borrow from your retirement account. Make sure you understand the consequences, and that you are prepared for a worst-case scenario. For some workers, the retirement account loan is the best option of last resort when funds from other sources aren’t available.