The money you save in a retirement account is intended for your retirement years, but it’s tempting to think about using it when you have a financial emergency. Financial experts agree that you should never touch retirement savings for ordinary purchases, but there are times when loans against retirement accounts make sense.
If you’ve investigated other borrowing alternatives and are still considering a retirement account loan, it’s important to understand the tax consequences as well as rules and regulations about repayment. You should also evaluate how secure you are about your job since changing employers affects when an outstanding loan is due.
Can You Borrow Against IRA?
The IRS prohibits loans from all types of IRA plans, including Simple and Roth accounts. If an IRA plan allows an IRA loan, the IRS will no longer recognize the account as an IRA and will treat the entire IRA balance as taxable income.
The account holder would also be subject to an early withdrawal penalty if younger than age 59 1/2.
There are circumstances under which you can take an IRA distribution without an early withdrawal penalty, such as buying a first-time home or paying tuition. This may be a better alternative than trying to take out a loan, but remember that a distribution diminishes your retirement balance and hurts the long-term growth of your account. Since this type of distribution is not a loan, it does not need to be paid back.
IRA 60-Day Rollover
The IRS does allow what amounts to a short-term loan on an IRA if you withdraw funds in order to roll them over into another IRA. You have a 60-day window to complete the transfer between accounts, during which you can treat the withdrawal as an interest-free loan. As long as you complete the rollover in time, you are free to use the money as you please.
There is some risk with this type of loan because the entire withdrawal will be treated as a taxable distribution if you don’t move it to a new IRA account before the deadline. Also, if you only roll over a portion, the part you kept as cash will be taxed as a distribution. As long as you roll over the IRA in time, you won’t have to pay taxes on it until you withdraw it from the new account. However, the IRS only allows you to roll over an IRA once within a 12-month period, so this isn’t a viable method for getting more than one short-term loan per year.
401(k) Retirement Plan Loans
The IRS allows 401(k) plans to offer loans; this is also the case for 403(b) and 457(b) plans. It’s up to individual plans to decide whether loans will be offered. Depending on the plan, this type of loan may be available to any employee with a vested balance or it may be tied to an immediate financial need.
One of the benefits of a 401(k) loan for borrowers with less-than-perfect credit is that you’re taking a loan from your own account, so no credit check is necessary. One more benefit with this type of loan is that you may be able to get a lower interest rate than with other types of borrowing.
401(k) Loan Limits
The IRS defines two limits on the amount of money you can borrow from a 401(k). The minimum limit is the greater of $10,000 or 50 percent of the vested account balance. The maximum limit is $50,000.
For example, an employee with $18,000 vested in a 401(k) can borrow $10,000, which is greater than 50 percent of the balance of $9,000. Another employee with a $130,000 balance can borrow just $50,000, even though 50 percent of the balance is $65,000, because the maximum loan limit is $50,000.
Repaying a 401(k) Loan
A 401(k) loan must be repaid within five years. Payments on the loan usually begin immediately and must be made at least once per quarter. If you don’t repay the loan on time, the entire amount can be treated like a distribution by the IRS, subject to income tax and a possible 10 percent early withdrawal tax if you are younger than 59 1/2.
Exceptions to Five-Year Repayment
A plan can extend the standard five-year repayment period for a 401(k) loan up to five more years if the loan is used for the down payment on the purchase of the employee’s principal residence.
The IRS allows a plan to suspend payment requirements while an employee is performing military service.
It’s also possible for employees who take a leave of absence to suspend loan repayment for up to one year, but in this case, the terms of the loan don’t change and final repayment still must take place within five years.
Can You Borrow Twice?
Unless a plan disallows it, there are no IRS rules against borrowing from a 401(k) plan more than once, even with an outstanding balance. The limit on the new loan takes the unpaid loan into account.
For example, if an employee with $90,000 vested in a 401(k) has an outstanding balance of $15,000 on a 401(k) loan of $30,000, a new loan could be taken out for $45,000 (50 percent of the balance) minus $15,000, which would be $30,000.
401(k) Loan Risks
There are some serious risks associated with 401(k) loans. If you leave your job while you have an outstanding balance, you may have a limited amount of time to repay the loan in full or have it treated as a distribution by the IRS. Don’t consider a 401(k) loan if you’re not secure about your job future or don’t have a clear idea about how you’ll repay it.
People who are close to retirement age and haven’t saved enough are usually advised not to borrow against their retirement. The only positive aspect about defaulting on a 401(k) loan for any reason is that it won’t affect your credit rating in the same way that defaulting on any other type of loan would.
Impact of a 401(k) Loan
A 401(k) loan won’t hurt your credit, even if you default on repayment and the loan is treated like a withdrawal. The biggest impact associated with a retirement fund loan is that until the loan is repaid, the balance of your retirement account is lower and will bring in lower investment earnings.
Also, many people stop contributing to a 401(k) that they’ve taken a loan against, so this means another reduction in retirement savings. There also may be fees associated with the loan that can further reduce your balance. It’s a good idea to investigate all the alternatives for borrowing before taking a 401(k) loan, including a bank or credit union loan, home equity line of credit or even a personal loan from a friend or relative.
2018 Tax Law
For 2017 and previous tax years, employees had 60 days to repay a 401(k) loan and avoid distribution taxes.
Changes to the tax laws in 2018 regarding 401(k) loans extend the repayment period for employees who leave their jobs to the due date for their next federal tax return, including extensions. This could give an employee up until October of the following year to repay the loan after leaving their job.