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The whole purpose of a retirement plan is to finance the years after you stop working. So financial planners generally encourage people to save as much as possible and to defer making withdrawals for as long as their plans allow. Taking a loan from your retirement account may can reduce the money of money you'll have later, but there are instances when taking such a loan makes sense. Here are some of the pros and cons of taking a loan from your retirement account.

Taking a loan vs. making a withdrawal

When you take a loan from your retirement plan, you are removing a portion of your balance. For instance, if you have $100,000 in your account and you borrow $40,000, you will have a balance of $60,000. However, taking out a loan is different from making a withdrawal. A withdrawal reduces the assets in your portfolio without requiring that you return the amount you withdrew, while a loan is treated as part of your portfolio and must be repaid.

Diversification

Diversification is an important part of retirement planning. Retirement planners usually recommend that assets be diversified according to the risk tolerance of the account holder. While planning is based on the past and projected performance of assets, the risk must be considered, except when it comes to assets that produce a guaranteed rate of return. One drawback of borrowing from your retirement plan is that the loan amount is no longer being invested in the portfolio of assets in your retirement account and, therefore, the opportunity for diversification using the money borrowed is lost until the money is repaid.

However, when you take a loan, the loan amount is treated as an asset in the plan, as it will be replaced by your promissory note. While the amount will not be diversified, it will receive a guaranteed rate of return, which could be an average of prime rate plus 2%. Remember that diversification carries risks, and it's possible to have a negative return on your investments unless some of your investments have a guaranteed rate of return. Therefore, the advantage of taking a loan from your account is that you will receive a guaranteed rate of return on the loan amount.

Double taxation

One argument against taking a loan from your retirement plan is that the amount you repay in interest will be taxed twice. This is because the loan repayments, including the interest, will be repaid with amounts that have already been taxed and will be taxed when withdrawn from the retirement account. Let's look at an example.

Assumption No. 1:

You contribute $100,000 to your retirement plan on a pretax basis.

The $100,000 accrues $10,000 in earnings.

You have never taken a loan from your retirement plan balance.

The $110,000 will be taxed at your ordinary income tax rate when withdrawn from your retirement account. Because the $100,000 came from pretax monies, and the earnings of $10,000 accrued on a pretax basis, the $110,000 will be taxed only when withdrawn.

Assumption No. 2:

You contribute $100,000 to your retirement plan on a pretax basis.

The $100,000 accrues $8,500 in earnings.

You took a loan of $20,000 from the plan, which you have repaid.

The interest repaid on the loan is $1,500.

The $110,000 will be taxed at your ordinary income tax rate when withdrawn from your retirement account. Since the $100,000 came from pretax monies, and the $8,500 earnings accrued on a pretax basis, the $108,500 will be taxed only when withdrawn. However, the $1,500 that came from interest repayment on the loan was repaid with money that had already been taxed, and it will be taxed again when you withdraw it. As a result, you will be paying taxes twice on the $1,500.

Consequences of failing to make repayments

With a few narrowly defined exceptions, loans taken from your retirement account must be repaid at least quarterly, and they must be repaid in level, amortized amounts of principal and interest. Failure to meet these requirements could result in the loan being deemed a taxable transaction. It would also mean that you lose the opportunity to accrue tax-deferred earnings on the amount and to make diversified investments with it.

If you leave your employer before the loan is repaid, you may be required to repay the entire balance within a short period, instead of over the established schedule. If you are unable to repay the balance, the plan may treat it as a distribution. Loan balances that are treated as distributions are subject not only to income tax, but also may be subject to the 10% early-distribution penalty.

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Why take a loan from your retirement plan?

You should take a loan from your retirement plan only if you have exhausted your other financing options, or if the loan will help to improve your finances. For instance, if you had credit card balances of $20,000 with an interest rate of 15% and you could afford to pay $400 per month, it might make sense to take a loan from your retirement plan in order to pay off your credit card balances. Let's compare the two scenarios:

Retirement plan loan amount

$20,000

Credit card balance

$20,000

Interest rate

4.5%

Interest rate

15%

Payment frequency

Biweekly

Payment frequency

Monthly

Payment amount

$171.94

Payment amount

$400

Repayment period

Five years

Repayment period (if repayment is $400/month)

Six years, seven months

Total interest

$2,351.41

Total interest

$11,582

While it is true that the $2,351.41 you pay in interest on your loan amount will be taxed twice, the obvious benefit is that the interest will be repaid to you, instead of to a credit card company, and the amount you pay in interest will be significantly lower.

If you do take a loan from your retirement account to pay off your credit card balance, make sure you take steps to avoid going into credit card debt again.

Another good reason to take a loan from your retirement account is to purchase a home. Depending on the market and your finances, buying a home can provide a significant return on investment. Furthermore, you could also use your home to finance your retirement, whether by selling it or by taking a reverse mortgage.

Check your plan provisions

Not all qualified plans allow loans, and some allow them only for special purposes, such as purchasing, building or rebuilding a primary residence, or paying for higher education or medical expenses. Others allow loans for any reason. Your plan administrator will be able to explain the loan provisions under your retirement account.

Replenish your account after you take a loan

If you must take a loan from your retirement account, try to continue making contributions and to increase the amounts you contribute. This may be a challenge, as you will also be required to make loan repayments, and those repayments will not be considered contributions to your retirement account. However, it will help you restore your nest egg more quickly.

Most plans will allow you to accelerate your loan repayments, which will help to restore your plan balance more quickly. Be sure to factor your loan repayment in your budget.

The bottom line

You should not take a loan from your retirement account unless it is an absolute necessity or it makes good financial sense. You will need to assess your finances and compare the retirement-plan loan with other options. It's a good idea to discuss the matter with your financial planner, so that he or she can help you decide which option is best for you.

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