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The gap in what you might have made will be wider still if your skipped contributions lead to missed matches to those funds by your employer—since such a perk essentially represents free investment money for you. The drawbacks above assume you'll be able to make the scheduled payments to your fund on time and without undue hardship. However, should you be unable to repay the loan, its financial implications go from bad to worse. That's because, should you default on a k loan, the loan is converted to a withdrawal.
As a result, unless you happen to qualify for a hardship withdrawal, the outstanding loan balance will be subject, at minimum, to taxation at your current income tax rate. If you quit or otherwise lose your job, you'll have only a mandated time within which you'll be required to repay an outstanding loan from your k or another retirement fund. Tax reforms that went into effect in lengthened that time from the previous 60 days after you leave a job to the due date of your next federal tax return, provided it's at least 60 days after your departure from the job.
Still, leaving your employer when you have an outstanding k loan is restrictive, to say the least. You'll be forced to come up with the outstanding balance in less time, most likely, than the five years, you would customarily have. If you can't repay the money, the loan will be treated as a withdrawal, with all the attendant implications for paying income tax and penalties.
Alternatively, the presence of a loan you'll have trouble repaying soon could handcuff you to a job you no longer enjoy, or force you to pass up a better opportunity should one come along.
Advisors who counsel against taking a k loan do so in part because these assets may one day represent the last possible asset to stave off financial disaster. If you exercise this "nuclear option" and tap the money now, when other options may still be available, your k may be depleted, at best, and its assets won't be there if and when your finances are truly desperate.
Borrowing from your future in such a literal way may—indeed, should—encourage you to examine if and how you got to this point in your finances.
The need to borrow from savings can be a helpful red flag—a warning that you are living beyond your means and need to consider changes to your lifestyle. When you can't find a way to fund your lifestyle, other than by taking money from your future, it's time to seriously re-evaluate your spending habits.
That includes creating, or adjusting, your budget and making an orderly plan to clear any accumulated debts. Advisers warn against having high confidence that you'll repay a loan from your k in a timely way—that is, in less than the five years that you're usually allowed to take out the funds. In part, that's because of the surprisingly large principal of such loans, especially among young people. Those numbers are hardly reassuring, however, when you consider that older k borrowers, even if they tap their accounts for less, may also have a shorter period before retirement in which to replenish the funds.
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Personal Finance. In most k plans, requesting a loan is quick and easy, requiring no lengthy applications or credit checks. Normally, it does not generate an inquiry against your credit or affect your credit score. Many k s allow loan requests to be made with a few clicks on a website, and you can have funds in your hand in a few days, with total privacy.
One innovation now being adopted by some plans is a debit card , through which multiple loans can be made instantly in small amounts. Although regulations specify a five-year amortizing repayment schedule , for most k loans, you can repay the plan loan faster with no prepayment penalty. Most plans allow loan repayment to be made conveniently through payroll deductions —using after-tax dollars, though, not the pretax ones funding your plan.
Your plan statements show credits to your loan account and your remaining principal balance, just like a regular bank loan statement. There is no cost other than perhaps a modest loan origination or administration fee to tap your own k money for short-term liquidity needs. Here's how it usually works:.
You specify the investment account s from which you want to borrow money, and those investments are liquidated for the duration of the loan. Therefore, you lose any positive earnings that would have been produced by those investments for a short period. And if the market is down, you are selling these investments more cheaply than at other times. The upside is that you also avoid any further investment losses on this money.
The cost advantage of a k loan is the equivalent of the interest rate charged on a comparable consumer loan minus any lost investment earnings on the principal you borrowed. Here is a simple formula:. Whenever you can estimate that the cost advantage will be positive, a plan loan can be attractive. Keep in mind that this calculation ignores any tax impact, which can increase the plan loan's advantage because consumer loan interest is repaid with after-tax dollars. As you make loan repayments to your k account, they usually are allocated back into your portfolio's investments.
You will repay the account a bit more than you borrowed from it, and the difference is called "interest. If the interest paid exceeds any lost investment earnings, taking a k loan can actually increase your retirement savings progress. Keep in mind, however, that this will proportionally reduce your personal non-retirement savings. The above discussion leads us to address another erroneous argument regarding k loans: By withdrawing funds, you'll drastically impede the performance of your portfolio and the building up of your retirement nest egg.
That's not necessarily true. First of all, as noted above, you do repay the funds, and you start doing so fairly soon. Given the long-term horizon of most k s, it's a pretty small and financially irrelevant interval. The percentage of k participants with outstanding plan loans in latest information , according to a study by the Employee Benefit Research Institute.
The other problem with the bad-impact-on-investments reasoning: It tends to assume the same rate of return over the years and—as recent events have made stunningly clear—the stock market doesn't work like that. A growth-oriented portfolio that's weighted toward equities will have ups and downs, especially in the short term. If your k is invested in stocks, the real impact of short-term loans on your retirement progress will depend on the current market environment.
The impact should be modestly negative in strong up markets, and it can be neutral, or even positive, in sideways or down markets. The grim but good news: the best time to take a loan is when you feel the stock market is vulnerable or weakening, such as during recessions.
Coincidentally, many people find that they need funds or to stay liquid during such periods. There are two other common arguments against k loans: The loans are not tax-efficient and they create enormous headaches when participants can't pay them off before leaving work or retiring.
Let's confront these myths with facts:. The claim is that k loans are tax-inefficient because they must be repaid with after-tax dollars, subjecting loan repayment to double taxation. Only the interest portion of the repayment is subject to such treatment. The media usually fail to note that the cost of double taxation on loan interest is often fairly small, compared with the cost of alternative ways to tap short-term liquidity.
She anticipates that she can repay this money from her salary in about a year. Here are three ways she can tap the cash:. Double taxation of k loan interest becomes a meaningful cost only when large amounts are borrowed and then repaid over multi-year periods.
Suppose you take a plan loan and then lose your job. You will have to repay the loan in full. While this scenario is an accurate description of tax law, it doesn't always reflect reality. At retirement or separation from employment, many people often choose to take part of their k money as a taxable distribution, especially if they are cash-strapped.
Having an unpaid loan balance has similar tax consequences to making this choice. Most plans do not require plan distributions at retirement or separation from service. People who want to avoid negative tax consequences can tap other sources to repay their k loans before taking a distribution. If they do so, the full plan balance can qualify for a tax-advantaged transfer or rollover. The more serious problem is to take k loans while working without having the intent or ability to repay them on schedule.
In this case, the unpaid loan balance is treated similarly to a hardship withdrawal , with negative tax consequences and perhaps also an unfavorable impact on plan participation rights. Regulations require k plan loans to be repaid on an amortizing basis that is, with a fixed repayment schedule in regular installments over not more than five years unless the loan is used to purchase a primary residence.
Longer payback periods are allowed for these particular loans. The IRS doesn't specify how long, though, so it's something to work out with your plan administrator. Borrowing from a k to completely finance a residential purchase may not be as attractive as taking out a mortgage loan. Personal loan terms could be easier for you to repay without having to jeopardize your retirement funds.
Depending on your lender, you can get your money within a day or so. A home equity line of credit , or HELOC, is a good option if you own your home and have enough equity to borrow against. Get a home equity loan. This type of loan can usually get you a lower interest rate, but keep in mind that your home is used as collateral. While easier to get, make sure you can pay this loan back or risk going into default on your home. If taking money from your retirement is your only option, then a k loan may be right for you.
However, try to find other funds first before tapping into this option. Depending on what you need and when you need it, you may have other choices that are better for your situation. How We Make Money. Editorial disclosure. James Royal. Written by. Bankrate senior reporter James F. Royal, Ph. Edited By Brian Beers. Edited by. Brian Beers. Brian Beers is the senior wealth editor at Bankrate. He oversees editorial coverage of banking, investing, the economy and all things money.
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