The ABCs of Why to Avoid Retirement Plan Loans

Retirement plans are often the highest balance accounts of our personal assets, so it is understandable to think of them when costs increase, and budgets get tight. The first thing to perhaps keep in mind is that those particular assets were set aside for a reason, with a specific future goal in mind. If that goal has not changed, then it is in all of our best interests to remain steadfast with the plan of growing our nest egg for the golden years of retirement.

So, what is the harm in tapping retirement accounts prematurely as a source of funds? If considering a withdrawal from a plan such as a 401(k), the full amount will be considered taxable income, with a hefty 10% penalty on top if done prior to age 59 1/2. How about taking a loan from the plan then? While not taxable at the time of receipt, there are unpalatable tax consequences to consider when borrowing from a 401(k). When repaying the loan back into your account (with interest) you do so with after tax dollars, setting yourself up to enjoy paying taxes on those same dollars again when later withdrawn from the plan in retirement. Another important consideration is the potential of disrupting your careful retirement planning as assets withdrawn are no longer able to compound and grow as originally intended. While assets are being paid back over a number of years, a strikingly large number of participants with 401(k) loans leave their jobs prior to fully repaying (roughly 85% according to the Bureau of Economic Research.) Those participants are left in the untenable situation of being forced to pay back their loans in a much shorter time frame than anticipated or suffer the tax consequences and potential penalties associated with taking a premature distribution.

Determining the consequences of covering large expenses from different sources of funding will likely have a host of considerations. The scenarios can vary based upon the direction of financial markets during the borrowing period, costs of alternative funding or the speed at which repayment can be made. While the pitfalls of borrowing from retirement noted above are only a part of the equation, they are certainly important factors to keep in mind. If you have come to a point in which borrowing from your future retirement funds seems to be the best option, perhaps it is time to take a step back and reach out to a financial professional who can fully explain the implications of such a decision and suggest alternatives that may be less detrimental to your long-term financial plan.