Crises that occur out of the blue may give you a reason to borrow from your retirement plan to provide initial relief to your predicament. However, it is wise to know the risks that come with a retirement plan loan to be alert to not letting short-term problems jeopardize future security.
Know the Stipulations
Approved retirement plan loans often stipulate that
- You sign a loan agreement agreeing to the terms.
- Pay according to a reasonable interest.
- It cannot exceed half of your already vested account balance.
- They usually have an estimated repayment period of around 5 years.
- The repayments would be required to be made regularly to both the principal amount and the interest.
- The individual would need to consult their spouse before taking the one.
What to consider before taking the loan
- Fees – A lot of record-keepers charge fees for issuing the loan and tracking payments and interest.
- Opportunity cost – Removing money from your retirement account that could potentially be earning more than the interest you are paying could cause you to miss an upswing in the market, this includes you missing out on the power of compounding interest.
- Pay tax twice – Loan repayments are often deducted from paychecks after taxes have been withheld, they do however go back into the individuals account as pre-tax assets.
- Reduced savings rates – Taking a loan to keep up with bills means, not having enough money to both repay the loan and continue contributing a portion of your pay into the plan. Some people stop saving while they are repaying, further shortchanging their retirement.
- Potential taxes and penalties – Some employers require the repayment within 60 days of leaving your job. Any unpaid balances would be treated as taxable income and there may be additional tax penalties to top it off.
Loan defaults
Often, over 80 percent of people who leave their job with an outstanding loan balance go into default. Failure to repay a loan or breaking any loan rules could result in not only losing a portion of one’s retirement savings, but also the defaulted loan amount being treated as a distribution, which is taxed as ordinary income.
How to prevent defaults
The only solution to avoiding a loan default is by not taking a loan from your retirement account in the first place. It is important to protect yourself today by planning for future financial surprises. This can be done through doing the following:
- Setting up an automatic deposit into a savings account each month to save more efficiently and effectively. This can be done from your primary checking, however, payroll department can make it even easier by permitting you to send a portion of your paycheck directly into a separate emergency savings account.
- Contemplate opening a savings account with different bank from your checking account. This makes you less likely to dip into it for non-emergencies.
- Withhold attaching a debit card to the account to resist spending temptations.
- Start an emergency fund by setting aside a portion of a tax refund.
Similar Article: 9 Retirement Questions to Ask as You Plan to Retire
Conclusion
Losing sight of the reason for your retirement plan savings does happen due to it being set for a future that has not even occurred yet. However, one must consider an account such as this off limits unless there is a dire need such as medical expenses or other equally financially challenging instances. Always try to compare the fees and interest rates for a line of credit, a home equity loan, and a personal loan in addition to a retirement plan loan.
