By: Kerstin Driscoll-Witt
Your SUITE(k) Retirement Plan Navigator
Does taking a loan from your retirement Plan make sense? Yes? Maybe? Sometimes? Never?
Let’s break it down! Many retirement plans offer a loan option for their employees, to allow easy access to retirement plan funds for any purpose. But how does it work?
These are the usual rules:
- You may borrow the lesser of $50,000 or 50% of your vested account balance. Your vested account balance is ‘how much you own’ of your total account balance. You may have a portion of your account you have not yet earned based on your service with your company.
- Your company may also require a minimum loan- eg. $1,000, which means you would need to have a vested balance of at least $2,000 to take a $1,000 loan (50% of your vested balance).
- You have 5 years to repay your loan, unless your Plan specifically allows for a longer term if used to purchase a primary residence. In this case, loan repayment may be allowed over, for example,10-30 years.
- Loan repayments are usually set up via payroll deduction, so each time you are paid, your loan payment is deducted and sent to your recordkeeper to pay your loan principal and interest.
- The Interest rate on the amount you borrow may be clearly defined in your Plan Document or determined by your Plan’s recordkeeper. The ‘usual rate’ is around prime rate or prime +1% or +2%.
So far, a Plan loan sounds like a decent option if you need access to money. Let’s see….
Why might a Plan loan not be such a great idea?
- Most loans are taken from ‘pre-tax’ or traditional sources. Loan repayments are always repaid after-tax, but co-mingled back with pre-tax dollars when you make your payments. What this means is that when you retire, you will be paying taxes on your ‘pre-tax’ account, which includes money (loan repayments and interest) that you have already paid tax on- so you will be paying taxes TWICE on the money you borrowed and interest. UGH! No one likes to pay taxes at all, let alone double tax on the same money!
- Let’s revisit borrowing $50,000 over 5 years. Including interest at 7.5%, this is a loan repayment of ~$231/ week for 5 years, or if bi-weekly, ~$462 for 5 years. The total interest paid over 5 years is ~10,000. Some employees fail to take into consideration the long-term impact on their take-home pay of the overall cost, principal and interest, paid to take a loan from their retirement plan.
- There is a common argument that Plan Loans are a ‘good idea’, because you are paying yourself interest. Is this true? Using the same $50,000 loan example, if you are paying yourself interest at prime rate (currently 7.5% on 5/6/25) and the average market return (2025 S&P YTD) is DOWN (3.52%), you are outperforming the market, so doing pretty well. But if it is 2024 and the average market return was UP +25.02%, but you are only paying yourself 7.5% interest, you wouldn’t be doing so great. Weighing your possible gain/ loss options depending on market volatility has to be part of your decision to take a loan.
Option: Consider borrowing outside of your retirement plan if possible, to allow the money in your plan to continue to benefit from compound interest, avoid possible taxation and provide stronger retirement outcomes.
- Fees- Plan loans may have a ‘loan origination/ processing fee’ plus quarterly or annual administration fees. It is important to take the loan fees into consideration if you are weighing the cost/ benefit of taking a plan loan or if you ae comparing fees to a loan requested outside of the Plan.
- Lastly, is a portability issue. If you terminate employment with your current employer, you may have limited options regarding your Plan loan. Something needs to be done with your outstanding loan balance, but what?
- Ask your new employer if their plan will allow you to roll your loan over to your new Plan and continue loan repayments- this may be possible, but it is rare.
- Ask your former employer if you may set up a payment plan to automatically fund loan repayments in accordance with your amortization schedule until paid in full. Again, possible, but rare.
- If neither of the above options is possible, you have two options left:
- Repay the outstanding loan balance in full, or
- If unable to repay your loan balance in full, your Plan recordkeeper will issue you a 1099 at the end of the calendar year, indicating that your outstanding loan balance was a distribution to you. At this point in time, your outstanding loan balance becomes taxable. This means that when you file your Income taxes the following year, you will need to cough up the taxes owed on the portion of the loan that was ‘distributed’ to you; the outstanding principal balance. In addition to any ordinary income tax (federal and state), if you are under age 59 ½, you will also owe a 10% tax for early distribution.
SAGE ADVICE: Talk through loan options with your significant other and your accountant, tax advisor or financial planner prior to punching a few keys and requesting a loan from your retirement plan. Your trusted advisor can help you understand the full implication of taking a plan loan and may offer other suggestions.
We can help! If you don’t have another resource, contact us. We can walk you through your options and help you make a more informed decision. Go to: www.401ktime.com/contact-us.
Make it great! Kerstin
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