How to Borrow Against a Retirement Account

Financial planners usually say that you shouldn’t borrow against a retirement account because that money is intended to help maintain your quality of life after you stop working. Taking a loan against a retirement account means you’ve decreased your potential earnings until you pay back the loan, but there are some situations when it makes financial sense. Making the down payment for a home is one reason to borrow from retirement. Refinancing a higher-interest loan when there are no other options is another. When you have exhausted all other options for borrowing, then a retirement account loan may be the way to go.

Borrow Against IRA

You aren’t allowed to borrow against an IRA, either Roth or traditional. You are not even allowed to withdraw money before age 59 1/2 without owing income tax as well as a 10 percent penalty tax. However, there are some special circumstances that allow you to withdraw from an IRA without this penalty. You can withdraw to help pay for a first-time home purchase or for a qualified college educational expense. You are also allowed to withdraw money early from an IRA if you become permanently disabled. This type of withdrawal is not an IRA loan, so you can’t avoid taxes by paying it back.

There is one way that you can get a very short-term loan from an IRA. The IRS has the so-called rollover rule, which says you can withdraw money from your account without penalty, provided the funds are rolled over into a new IRA or deposited back into the same IRA within 60 days. The rollover rule is designed to give people time to move money between IRA accounts, but there is nothing to stop you from using the money for an emergency or other expense during the 60 days when it’s between IRA accounts. This is the equivalent of an interest-free loan.

Once you’ve rolled over funds from an IRA, you can't do it again for 12 months, so this isn’t a practical solution for a long-term loan. If you don’t redeposit a rollover from an IRA, it will be treated as a distribution and you could be subject to a 10 percent penalty if you are younger than age 59 1/2.

Borrowing From a 401(k)

Most employer-sponsored 401(k) retirement plans allow employees to borrow from their own accounts. The amount you can borrow is limited by the IRS to 50 percent of your vested balance, up to $50,000. For example, if you have $60,000 in your retirement account, the most you can borrow is $30,000. A retirement loan is not the same as a hardship withdrawal, which also may be allowed from your plan. You should not be required to show financial hardship in order to qualify to borrow from our 401(k).

Your employer is responsible for providing details about borrowing against your 401(k) as well as repaying the loan. Depending on your plan, you may be required to get your spouse’s written consent before the loan is finalized. The IRS requires the loan to be repaid within 5 years and payments towards the interest and principal of the loan must be made at least quarterly. However, if you are borrowing against retirement for a home purchase, the IRS allows you to take more than five years to repay it.

401(k) Loans Pros and Cons

One of the biggest benefits of taking out a 401(k) loan is that you aren’t subject to a credit check since you’re essentially borrowing your own money. You may be able to get a lower interest rate with this type of loan compared to one from a financial institution. The loan interest rate for many plans is 1 or 2 percent above the prime rate. A 401(k) loan is not treated like a distribution, so you won’t be required to pay taxes on it as long as you satisfy the repayment terms of the loan.

Even with all these benefits, you should carefully consider the repercussions of a 401(k) loan. People are living longer in retirement without the benefit of a workplace pension, so it’s important to safeguard your retirement savings. If you borrow against your retirement account, your investment growth will be reduced until the loan is repaid. In addition, many people stop making regular contributions to their 401(k) until they pay back their loan, further slowing the growth of their retirement fund. Lower contributions could mean missing out on employer matching contributions. This is why financial experts say you should make sure you’ve looked into all other avenues for borrowing, including a home equity line of credit, before you consider this type of loan.

Repaying a 401(k) Loan

One distinct disadvantage of repaying a 401(k) loan is that you must do so with after-tax money, even though you contribute to the account with pre-tax dollars. When you get around to taking 401(k) distributions during retirement, you will be taxed again. So the same funds are effectively taxed twice.

If you default on repayment of a loan from your 401(k), the entire outstanding balance of the loan will be treated like a taxable distribution and you will be responsible for early distribution taxes. If you are younger than 59 1/2, you may also have to pay a 10 percent penalty to the IRS for taking an early distribution. It’s a good idea to set up automatic payments on a 401(k) loan to avoid going into default for missed payments and owing distribution taxes.

If an employee who borrows from their 401(k) is a member of the armed forces, loan repayment can be suspended while the employee is on active duty. The length of the loan can then be extended to compensate for the period of suspension. Repayment of a 401(k) loan can also be extended when an employee who is not in the military takes a leave of absence from work and is unable to make loan payments. In this case, however, the length of the loan cannot be extended and the final payment still must be made on time or the loan will be treated as a distribution.

If You Leave Your Job

If you quit your job or are terminated while you have an outstanding balance on a 401(k) loan, your employer may require you to repay the loan in full immediately within a specific time period. If you’re unable to pay the loan back within this period, it will be treated as a distribution that is subject to taxes and a possible early withdrawal penalty, depending on your age. It may a good idea to only take a 401(k) loan if you feel secure in your job, at least as long as the loan is outstanding.

2017 Tax Law

For taxes paid prior to the 2018 tax reform, you had 60 days after leaving your job to pay back an outstanding 401(k) loan. The entire loan would have to be repaid at that time or it would be treated as a distribution that you would owe taxes on.

2018 Tax Law

Tax law changes in 2018 make it slightly easier to repay a 401(k) if you leave your job. The due date for loan repayment has been extended until the due date of your next tax return, including extensions. If the balance of the loan is not paid at that time, it will be treated as a taxable distribution.

Tip

  • If your spouse has an IRA, you can double the term of the 60 day loan by redepositing funds into your IRA by making a tax-free rollover withdrawal from your spouse's IRA. You then have 60 additional days to replace the money in your spouse's account.

Warning

  • If you exceed the 60-day time-frame to redeposit funds in an IRA, the money is treated as a regular distribution, and you could owe taxes and penalties. An IRA can only be involved in a tax-free rollover once in a 12 month time frame. This includes the account that you withdrew the money from as well as the account you redeposit the money into. If you lose your job and have an outstanding 401(k) loan, the loan balance is treated as a withdrawal and subject to taxes and penalties, unless you repay the loan.

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About the Author

Catie Watson spent three decades in the corporate world before becoming a freelance writer. She has an English degree from UC Berkeley and specializes in topics related to personal finance, careers and business.


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