When life throws you a financial curve ball, it can be pretty tempting to dip into your retirement plan for help. After all, it’s money you have saved for yourself, right? Maybe. But there are a few really important things you need to know before you make the decision to take money out of a retirement plan. Most of these consequences CANNOT be reversed, so choose wisely!
401(k) and 403(b) Loans
Loaning yourself money from your employer-sponsored plan can be a pretty attractive option when you are facing a financial calamity. And it may be a good option depending on your situation. 401(k) and 403(b) loans usually carry a lower interest rate than a credit card. So there is the comforting idea that you are “paying yourself back” rather than throwing away the interest to a credit card company. Furthermore, this type of “loan” isn’t actually a loan in that it has no impact on your credit rating. You’re basically moving money from your long-term pocket to your short-term pocket and back again as you pay off the loan.
However, there’s a big catch that most people don’t think about: your loan becomes due, in full, after you leave that employer. If you don’t pay back the loan within the grace period after you leave a job, not only does the full amount become taxable; an additional 10% penalty is applied if you are under the age of 59 ½. This can make the cost of your loan far greater than you originally intended.
You probably don’t intend to leave your employer, but since most of these types of loans last for five years, people often forget about this after a year or two and face an unpleasant surprise later on. I encounter this most often when clients try to roll over on old 401(k), and it’s not fun. The solution? Either don’t take out a loan in the first place, or try to shorten the life of the loan as much as possible by paying it off quickly (more than the minimum payments).
These are commonly misunderstood, so I want to make it clear: there is no such thing as an IRA loan. You cannot “pay yourself back” after you take a distribution from an IRA (this includes SEP and SIMPLE IRAs, as well). Once the money has left the IRA, it has left the building.
You can potentially make future contributions, but the compounding power that is a key feature of these plans has been irrevocably damaged. In other words, when you take money out early, you sacrifice the potential investment gains you could have earned. It’s like taking a cake out of the oven before it has fully cooked. What you end up with is an unappetizing mess, rather than the culinary delight you had intended when you started the recipe.
Another problem, if you are under age 59 ½, is the taxes and penalties involved. People are often surprised to learn how expensive a premature IRA distribution can be: your normal tax rate (for most people, around 22%) PLUS a 10% early withdrawal penalty, or around 32% for most people. That is likely higher than the interest rate on a credit card. Do the math and weigh your options carefully when faced with this situation.
Sometimes people try to get clever with the “60-day rule” for IRA distributions, which allows you to replace the money back into your IRA within 60 days. Yes, it’s a loophole you can access, but it’s complicated and risky. Do you really want to take that chance? In my experience, these often do not go as planned, and end up causing more hassle and stress than monetary advantages.
There are other ways to qualify for an exception to the 10% penalty, but again, they can be tricky and a recordkeeping nightmare, so I don’t usually encourage them. Keep in mind, IRAs were created for retirement savings. So it’s not really surprising that the rules around taking money out for purposes other than retirement are pretty strict. An IRA distribution should be considered a last resort.
This is where having an emergency savings account can be priceless. In fact, life’s curve balls are exactly what your “rainy day fund” is for! Make savings a priority, no matter what stage you are at in life. When the unexpected happens, you will be so much happier and less stressed.
Other financial tools you might consider include a 0% interest rate credit card intro offer, if you qualify and you are sure you can pay the card off within the introductory period. You might also consider contacting your bank regarding a personal loan. The terms likely won’t be as favorable as a 401(k) or 403(b) loan, but they are likely to be more advantageous than an early IRA distribution.
Lastly, depending on what you need money for, you might consider negotiating with the lender to see if they can offer you more time or a lower interest rate. For example, medical providers are often able to work with you on a payment plan. Or, if you have been a long-time customer with a good payment record, point that out. Companies want to keep good customers. In any case, it doesn’t hurt to ask.
Knowledge is power, my friends. I hope you use this knowledge about various “loans” to make smarter financial decisions. If we can help you figure out the best options for your situation, please do not hesitate to reach out.