Taking a loan from your retirement plan is a big decision and should not be done lightly.  If you have an immediate financial need, however, you are likely considering all the ways that you might meet that need.  Before taking a loan from your retirement plan, consider the pros and cons below.


Pros:  

  • Loan Amount is Withdrawn Tax Free:  Unlike a cash distribution from your plan that can be subject to ordinary income taxes plus early withdrawal penalties, a loan from your retirement plan is taken tax free.  A loan allows you to use the money without incurring a taxable event so long as you continue to pay the loan back.  
  • Interest Expense is Paid Back to You:  Your plan is required by law to charge a reasonable rate of interest for your loan. The plan's loan rate will typically be pegged to the prime rate plus 1 or 2 percentage points.  Although this interest makes the loan more expensive, when you pay back this interest, you pay it back to your own account.  In contrast, if you took a loan from a bank or another lender, the interest payments would be paid to a third party.
  • Taking a Loan is Relatively Easy:  In most instances, when you take a loan, you have to be approved.  The paperwork is often involved and you may need to qualify and pass certain credit checks.  Although there is an approval process and loan paperwork, relative to most other loan processes your retirement plan loan will be pretty straightforward since you are effectively borrowing the money from yourself.
  • Easy Payments:  For most plans, your loan payments will be automatically deducted from your paycheck and applied against your loan.  This payroll deduction makes repaying your loan easy and automatic.   


Cons:

  • Borrowing from Future You:  Significantly, borrowing from your retirement plan reduces your future account value even if you pay back your loan completely.  While circumstances may sometimes require that you borrow from your retirement plan, you are reducing the amount of money you have working for you and undermining your ability to compound your earnings.  Younger you is effectively borrowing from future you.
  • Double Taxation on Interest Payments:  Loan payments are made on an after-tax basis.  Your loan payments will include your interest expense.  Your interest payments will get taxed once when the contribution is made and then will be taxed again when your account balance is distributed at retirement.  This double taxation is a hidden but real cost of taking a loan.
  • Loan Processing Costs:  Your plan is going to charge you a loan processing fee and an annual loan maintenance fee.  Those fees help to offset the costs to the plan of processing your loan and making regular payments.  However, those costs make the effective cost of the loan much higher, especially for small loans.
  • Risk of Loan Default:  Delinquent loans continue to accrue interest until the loan is fully paid off, or until the loan has officially defaulted. If your loan defaults, then your outstanding loan balance is reported to the IRS as a taxable distribution rather than a loan. For the year of the loan default, the outstanding balance is subject to Federal taxes, State taxes (where applicable), and may be subject to a 10% penalty.


Bottom line?  Taking a loan from your retirement account can be costly and can undermine your future retirement security.  However, if you have a pressing financial need, a loan from your retirement account can be a life saver and can be a better option than many other borrowing or withdrawal options.


Any tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed herein. BlueStar Retirement Services, Inc. This bulletin is published as a general informational source. This information is general in nature and is not intended to constitute legal advice in any particular matter. BlueStar Retirement Services, Inc. does not warrant and is not responsible for errors or omissions in the content of this report.