Nobody wants debt hanging over their head, especially the high-interest kind. Among the options available to destroy it, doesn’t it make sense to borrow from yourself?
Here’s this week’s reader question:
My question is, I have some money in my retirement account. Is it better to borrow some of that money to pay down debt if you don’t have any other additional financial resources coming in to pay down the debt, or should you keep funding retirement and paying down the debt slowly as best as you can? — Stephanie
Before we get to Stephanie’s question, here’s a video I did a while back about digging out of debt. It’s one of my favorites because it’s the only news story I’ve ever done while wearing a Hawaiian shirt.
Now, on to Stephanie’s question:
Can you borrow from your retirement plan?
The law allows loans from common qualified retirement plans, like 401(k)s and their nonprofit cousins, 403(b)s. But while the law allows loans, plans aren’t required to offer them. So first see if your plan allows loans, and if so, what kind. For example, some plans only allow hardship loans, meaning you’ll have to be in dire straits, like facing eviction, to qualify. Others allow you to borrow for any reason.
The most you can borrow from most qualified retirement plans is the lesser of $50,000 or 50 percent of your vested balance, although some plans have an exception that allows loans of up to $10,000 even if 50 percent of the vested balance is less than $10,000.
The longest you can take to pay the loan back is five years, longer if the loan is to finance a house.
You’ll pay interest at the rate established by the plan. But the interest you pay goes into your account, so you’re paying it to yourself. Doesn’t that beat borrowing from a bank, or paying 20 percent on a credit card?
You’d think so, but let’s go over the drawbacks.
Why borrowing from retirement accounts is bad
- You’re putting the brakes on your savings. Many retirement plans prohibit making additional contributions to your account until the loan is repaid. So when you borrow, you’re not building your retirement savings. And even if you can continue contributing, can you afford to do that and make payments at the same time?
- You’re not making as much. Sure, you’re paying interest to yourself on the amount you borrowed. But that interest may not be as much as the returns you could have achieved in stock mutual funds or other investments in your account. You’re obviously also not making money on the money you could have contributed, but now can’t.
- You’re repaying the loan with after-tax money. When you make regular contributions to your retirement account, those contributions aren’t taxed. But when you pay back your loan, the income you’re using is after-tax. For example, if you’re in the 25 percent bracket, you’ll have to make $100 to pay $75 of your loan. And the interest you pay isn’t tax-deductible.
- Better be able to pay it back. Should anything arise that prevents timely repayment of the loan, it can become a withdrawal, subject to income taxes and a 10 percent penalty.
- Better love your job. If you lose your job, you’ll have to pay the money back quickly, typically within 60 days. Otherwise, as above, you’ll be both taxed and penalized.
- There could be a loan origination fee. Ask your employer.
There are calculators online that can help you determine the impact of a 401(k) loan on your retirement savings, like this one from Vanguard.
When borrowing from retirement accounts makes sense
You’d think after reading the above that nobody should ever borrow against a retirement plan. Yet, it’s common. According to the Employee Benefit Research Institute, about 20 percent of those eligible for a 401(k) loan at the end of 2014 had one. Here are some examples of when they might be appropriate:
- When you have no other choice. If your back is against the wall and you have no other options, the decision is easy.
- When it’s the best you can do. If you really need money, these loans may be the least expensive way to get it, in terms of interest, fees and convenience.
- When the math works out. If you’re paying 21 percent on a credit card and repay your retirement account at 5 percent, you’re obviously money ahead by borrowing. And this can be especially true if …
- Your investments are about to crash. When you take money out of your retirement plan, or are paying off a loan with new contributions, that money isn’t available to earn anything in whatever investments you’ve selected. The more the market takes off after you remove and pay back the money, the higher your opportunity cost. But if the market goes down, you were certainly better off using the money to pay off a 21 percent credit card than watching your balance crater. If your investments have doubled over the last several years, this is a backdoor way of locking in some profits.
What should Stephanie do?
So far, all I’ve done is recite the pluses and minuses of retirement plan loans. While important, they don’t answer Stephanie’s question.
Whenever someone asks me about borrowing more to deal with debt, the first question I have is, “Why are you in debt in the first place?” If you have debt because you’re regularly spending more than you’re making, all you’re doing is kicking the can down the road. While some options may prolong the agony more than others, in the end you’re in the same place: bankruptcy court.
If, however, the debt you’re dealing with arose because of a temporary and now resolved situation, such as an illness or job loss, great. The less interest you pay, the sooner you’ll recover.
If Stephanie is having trouble making ends meet, she should seek help from a qualified credit counselor. If she simply has some high-interest debt she’d like to pay off, and can keep it paid off when she’s done, a loan from her retirement plan could work, especially if she can continue making regular contributions in addition to the loan payments.
But she should realize that the less she fiddles with her retirement nest egg, the better. Retirement plans aren’t piggy banks. They’re how you’re going to stay alive and enjoy life when you’re no longer able to work.
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I founded Money Talks News in 1991. I’m a CPA and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. I’ve been investing in both stocks and real estate for more than 35 years.
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