Retirement Plan Loans: To Borrow or Not to Borrow?

Retirement Loan

Participating in the company’s retirement plan is a smart (and important) decision. Smart because you are putting away small amounts today for a comfortable retirement later.

As your account begins to grow, it may be tempting to “dip into” your retirement savings by taking a loan against your retirement plan to pay your annual taxes, repair a leaking roof, catch up on your everyday pile of bills and so on. And while the decision to take a plan loan is yours to make, we want to ensure that you consider what it will really cost.

With a retirement plan loan, you pay yourself back the amount plus interest. But the true cost can be shown with the loss in your retirement savings.

Below are a few of the drawbacks to taking a loan from your retirement plan:

Unlike retirement plan contributions, repayments for loans are made on an “after-tax” basis. That means that you use dollars that have already been taxed for your loan payments. Then, you pay tax again on your distributions at retirement. Thus, you will pay taxes twice on your loan amount.

Loss of Saving
Most workers that borrow from their retirement plan cannot afford to pay back the loan as well as continue to save in the plan. Thus, they end up only paying back the principal and interest for the loan, and not saving for their future.

Loss of Compounding Return
The dollars that you borrow earn nothing for you. Most people who borrow money reduce their savings amounts and upon employment termination can’t afford to pay back the loan. These factors contribute to the loss of time and compounding return on savings.

Cost of Interest Payments
Although the interest that you will pay on the loan will be paid back to yourself, the amount you borrow will not earn you anything. The dollars you use for the interest are already your dollars. It’s like taking money from one pocket and putting it into another. You already have the money!

Repayment Upon Employment Termination
If you terminate employment the outstanding balance of your loan becomes due immediately. If you can’t afford to pay back the outstanding balance, it then becomes taxed and penalized as a pre-retirement distribution (assuming you are under age 59 1/2). Therefore, you pay federal and state income tax. Generally, workers that borrow money are unable to pay back any outstanding balance upon employment termination. In addition, they have the tax consequence to pay at tax return time!

For more information regarding your retirement plan, please contact your plan’s advisor.