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Borrowing From Your Retirement
Understanding loans from workplace savings plans
We've all heard that we should have enough cash to cover three to six months of expenses stashed in an emergency account. But what happens if you need more? Or if an emergency strikes and you aren’t prepared?
Well, if you have an essential expense and don’t have the money to cover it you will probably begin looking at your credit options. Most Americans have credit cards, many have access to bank loans or other lines of credit, and some tap into another source: their own retirement plans.
Workplace plan loans are widely available: according to a recent study by the Employee Benefit Research Institute, 88% of 401(k) retirement plan participants have access to a loan from their savings plan.1 Plans may choose to offer these loans to give their participants a way to access some cash, but deciding if you should use one is complicated. Like any loan, you have to consider the costs and fees of borrowing and your ability to handle the debt. But in many ways, borrowing from your own retirement savings plan is different. There are some major advantages, like paying interest to yourself instead of a bank, but there are also unique risks and costs that you should consider before you tap into your nest egg.
“For potential borrowers who will be able to comfortably pay off their loan, the workplace option should be compared to other lenders to see if the total cost of the financing is cheaper,” says Stephen Barkhuff, CFP® and senior quantitative analyst at Strategic Advisers, part of Fidelity Investments. “But, because of the special rules surrounding loans from workplace savings plans they aren’t for everyone. If you can’t be sure you will be able to pay off the loan on time while continuing to save for retirement, or if you won’t be able to repay the loan in the event that you lose or leave your job, you should look elsewhere for credit or re-evaluate your need for the loan.”
Do you really need this?
Retirement Plan Loan Basics
Before you take on debt, you should ask yourself if it’s worth it. No matter where you get your loan, debt is going to cost you. First, there are the hard costs in the form of fees and interest payments. But debt also reduces your financial flexibility. If your future income is already earmarked for debt payments, you can’t use that money to respond to emergencies, save for your goals like college or retirement, or reward yourself with a vacation or other indulgence.
“We all need to be careful about debt,” says Chris McDermott, senior vice president, investor education, retirement, and financial planning at Fidelity. “Debt can be expensive, especially high interest debt like credit cards. When you’re stuck in a situation with an essential expense you can’t cover, it pays to be a smart borrower and explore all your options.”
If you do need a loan, it makes sense to compare the terms of the loans offered by credit cards, banks, and your retirement savings plan. The federal government provides some general guidelines for plan loans, like a maximum loan repayment period of five years, except for loans used to purchase a primary residence, and a maximum limit on the size of the loan (see the table below). But critical elements are left up to each individual plan, including whether or not to offer a loan, the interest rate, sizes, fees, loan requirements, and repayment schedule.2
If you are comparing a 401(k) or 403(b) loan with a bank loan or credit card, be sure to get details on your plan’s interest rate, fees, and other loan terms, and compare them to your other choices.
Beyond the normal considerations for a loan, borrowing from your retirement plan has some unique considerations. In the wake of the 2008 credit crisis, gaining access to a bank loan has become more difficult, and rates for many borrowers have risen. With a loan from your workplace savings plan, you won’t need to pass a credit check. And that’s not all. Generally, the loan application process is much more complicated at your bank than at your retirement plan account. But maybe the biggest benefit of borrowing from yourself is interest. When you pay a loan off with a bank, they keep the interest. When you borrow from your own retirement, you pay the interest back to yourself—instead of handing it over to a bank or credit card.
Some unique penalties
Sounds great, right? Not so fast. A lot of the benefits of loans from your retirement plans are double-edged swords. Among the risks to consider:
“You don’t want to rob your future to pay for today,” says McDermott. “If you take a loan from your workplace savings plan and it ends up costing you the ability to save for retirement—or even worse, you can’t pay it back—your retirement could suffer in a way you might not be able to fix down the road.”
A taxing situation
There is one other cost to consider. If you do take a loan from your retirement plan, the interest payments are not tax deductible, just as with a car loan. So, unlike pretax contributions to your workplace savings plan, your interest payments will not reduce your taxable income today, and they will be taxed again when that money is withdrawn from your account.
Also, conventional loans that are used to purchase a house or home equity loans used for home improvement or repairs are generally tax deductible. That’s not true if you borrow the money from your retirement plan. If you itemize deductions, that could make a difference to your bottom line.
Rethinking your mix
Once you have a plan in place to pay yourself back on time and avoid distribution penalties, you should next consider your loan as you manage your mix of stocks and bonds. Why? Because instead of having the potential to earn investment returns or suffer losses in the market, the outstanding balance of your loan will be earning the interest you pay into your workplace savings account. Those payments of principal and interest share some similarities to a bond: both offer a preset interest payment over a period of time.
As a result, it might be helpful to think of your loan as part of the fixed income portion of your portfolio. What does that mean for your asset allocation? It may mean you need to increase the amount of money you invest in stocks to keep the same portion of your portfolio in the equity markets.
Look at the example below. In this example, taking the loan adds to the fixed income portion of the investment mix. How to react? To get back to the original asset mix, increase the stock allocation. The loan, plus the remaining fixed income investment, will keep the mix in line with the original.
As you repay your loan, you should monitor and adjust your mix to stay in line with your targets. Staying in line with your target mix may help to manage the impact of a loan on your opportunity to earn returns in the markets. Having the right mix is especially important if you have a longer-term loan, for instance if you borrow for your primary residence.
So when does a workplace loan make sense?“When taking a loan you should seek out the lowest cost source of credit after taking tax deductions, fees, and other considerations into account,” said Barkhuff. “If your workplace savings plan is the lowest cost, then it may be fine. But you should be very aware of the risk to your retirement if you can’t make contributions while you pay off the loan, or if you fail to pay off the loan. If you can’t manage those risks you should consider borrowing from someplace else or reconsider your need to borrow.”
About the chart "What a Loan Might Mean for Your Retirement": Assumes today's date is 1/1/2010, the participant was born Jan. 1, 1970, and has saved $50,000 in a 401(k). Participant has a balanced portfolio (50% stocks/40% bonds/10% cash), no other savings, and earns $60,000 each year and saves 5% of salary to the 401(k). Employer matches dollar for dollar up to 5%. Salary increases at a real rate of 1.5% per year. Participant works for 25 more years and retires at age 65. Participant lives in a state with no income tax. The loan is $20,000 for five years at an interest rate of 5.25%. The 401(k) assets are reduced pro rata, and this assumes no fees.
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