How to Make a Loan Against Your Retirement Accounts

December 23, 2019 by First Federal Bank

A couple reviews documents and a laptop togetherSaving for retirement is meant to help you finance your future, improving your quality of life after your work years. The more you are able to set aside and the longer you allow that money to accrue, the more cash you’ll have to live on. Because of this, it’s recommended to defer taking funds from your retirement savings as long as possible — but there are situations in which it may be necessary, and qualified plans like 401(k) or 403(b) plans do give you the option to do just that.

Taking out a loan vs withdrawing from your retirement

Taking out a loan from your retirement account is not the same as withdrawing money from it. You are not required to return the amount of money you withdraw, but “a loan must be repaid to the plan in order to avoid it being considered a taxable event,” says Denise Appleby, CEO of a retirement consulting firm. Typically, making a withdrawal from a 401(k) account when you are younger than 59 and a half years old would normally mean you pay a tax penalty. The loan allows you to use the money when you need cash without losing it to the IRS. Another upside, according to Appleby, is that the interest you repay on a qualified plan loan is repaid to your plan account rather than to a financial institution.

Federal loan regulations

There are limitations to the types of retirement plans you can borrow from. The Internal Revenue Service says you cannot take a loan from an IRA retirement plan or an IRA-based plan. “If the owner of an IRA borrows from the IRA, the IRA is no longer an IRA, and the value of the entire IRA is included in the owner’s income,” the IRS explains. Additionally, you cannot tap into a 401(k) account from a company you no longer work for — at least not until you’ve rolled it into your current plan.

Even if you have a qualified retirement plan, there are still limitations to the amount you can take out. Any single loan cannot exceed $50,000 or half of your vested account balance, whichever is less. If you have between $10,000 and $20,000 in your account, however, you may be able to borrow as much as $10,000 even if it is more than half the total. Additionally, while you may have more than one outstanding loan from your plan at a time, any new loan cannot exceed the plan maximum amount.

The IRS has many rules and potential exceptions governing these types of loans, so it’s best to work with your local financial institution when assessing your options.

Qualified plan loan rules

Even if the IRS says a qualified plan can offer loans, the plan itself is not required to allow you to do so. “Some plans, for instance, allow loans only for what they define as hardship circumstances, such as the threat of being evicted from your home due to your inability to pay your rent or mortgage, or the need for medical expenses or higher-education expenses for you or a family member,” Appleby explains.

While some plans may allow you to borrow against your retirement savings for just about any reason, others may require you to have exhausted all of your other options first. You will need to consult your plan administrator or employer to learn if your plan offers loans and, if it does, what the restrictions are.

Repaying the loan

Typically, you must repay a loan from a qualified retirement plan in no more than five years, though once again there are exceptions. The loan repayment period can be extended when the loan is used to purchase a primary residence, and shortened if your employment is terminated. “Previously, if your employment ended before you repaid the loan, there was generally a 60-day window to pay the outstanding balance,” Appleby says. “Starting in 2018, the tax overhaul extended that time frame until the due date of your federal income tax return, including filing extensions.”

Just as with financial institution loans, an amortization schedule governs your repayment schedule and amount, including interest. You will need to pay at least on a quarterly basis, but if you are unable to pay and your loan is in good standing, you may be able to treat the amount due as a taxable distribution, since it was your own money to begin with. This is not ideal for building up your retirement savings, so it’s possible to make a rollover contribution to an eligible retirement plan if you can come up with the amount within 60 days.

Making a loan against your retirement savings is an important decision with a lot of variables. Before you’ve determined whether to go through with it, make sure to talk with your financial planner.

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