Retirement Plan Loans

When you look at your retirement plan's block of money “just sitting there,” it may be tempting to borrow from your retirement for more immediate needs. This isn’t a decision to be made lightly. Some retirement plans – such as IRAs, SEPs, SIMPLE IRAs and SARSEPs – don't allow loans at all. And once money is borrowed from an IRA, the account is no longer an IRA – the value of the entire account becomes taxable and must be included in income.

Borrowing from a 401(k)

While federal rules may allow borrowing from your 401(k) account, the biggest question isn’t whether you can borrow, but whether you should. We suggest talking with a financial advisor before you make that move. In the meantime, there are some considerations you can make on your own.

First, why do you need the loan? If it’s for a dream vacation or a new living room carpet, we'd say think again. But if you’re trying to get out from under credit card debt and a really high interest rate, you might be onto something there.

Second, can you compare the cost of repaying a loan from your retirement plan against another option? Whether you borrow from your own retirement plan or from a financial institution, you'll have to pay interest. Which will be higher? Also, remember that borrowed funds aren't earning adding growth to your retirement account.

Finally, some plans require borrowers to suspend contributions to their plan for a certain time, which means it could take longer to get the fund back to where you started.

How Much Can I Get?

Qualified plans limit how much you might borrow. Basically, your loan is capped at either $50,000 or half of your vested balance in the plan (that’s the amount of money you have rights to get now, according to your plan rules) – whichever is smaller. If your vested balance is less than $10,000, plans can make an exception, but not all do.

Repaying the Loan

Then there’s the little matter of paying back the retirement plan for that “easy” money you borrow. Again, there are limits. Usually, loans from qualified plans have to be repaid within five years. More time is allowed when borrowing to buy a primary residence.

The loan payments will be spread out – amortized – over a schedule prepared by the plan administrator. If payments are not made, the entire loan amount could be taxable and would be reported to the IRS as such.

If you leave your job through termination or other means, and you have an outstanding loan balance, your employer could require you to repay the balance of the loan in full. If you can’t repay it at that time, you might be able to treat the outstanding balance as a distribution. If the plan administrator agrees, you and the IRS would get a Form 1099-R reporting the distribution. You can avoid income tax on the distribution at that point if you can come up with the unpaid balance amount before you file your taxes for the year.