Loans Permitted From Some Retirement Accounts
Early withdrawals, prior to age 59 ½, are permitted this year without the customary 10% penalty. Loans from certain retirement accounts are available for up to $100,000 or 100% of the vested interest in an account. To qualify, the withdrawal must be coronavirus related. There is a 3 year window to pay the loan back, with interest, before it is considered a normal distribution and taxed as ordinary income. This is available for 401(k), profit sharing accounts, 403(a) and (b) and some 457 accounts. Contact us or your plan administrator to find out if your account qualifies.
It may seem alluring to take a loan from your retirement account, after all, you are paying yourself back, with interest, usually at a rate lower than commercial loans. However, there are a number of reasons why this may not be as good as it seems. First of all, your funds are likely coming out of your account at low point in the market. So you are realizing the lower market values by liquidating your holdings at a dip in the market. Over the next three years as you slowly repay the account, your money is not invested and you won’t participate in the market rise that is likely coming at the end of this crisis. You also forgo any dividends and interest that would have been paid on your holdings.
You are being taxed twice on the money used to repay the loan. When you contribute to your retirement account, you use pre-tax dollars. So a dollar of salary equals a dollar of account contribution. When repaying your loan, you use post-tax dollars. For someone in the 24% tax bracket, your dollar of salary becomes $0.76 of available loan repayment after you pay income taxes. You are eventually taxed on that money again when you go to withdraw it.
Finally, when investors are repaying their loans, they may not be able to keep up with the contributions they would normally be making to their account. If this is the case, they end up missing out on any matching contributions made by their employer.
Our recommendation is to borrow from your retirement account as a last resort, if no other means are available to you. If you need to take a hardship loan from your account, do it with eyes open, knowing all the hidden costs of this option. If you’d like to discuss your options further, please call us.