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Loans and Hardship Withdrawals:
In Case of Emergency |
| Life is unpredictable. Cars break down and furnaces need replacing. So what happens if you really need the money in your retirement plan before you retire? |
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| Some retirement plans allow you to withdraw money for special circumstances such as large medical bills, or to prevent foreclosure on your home (it is up to each plan to decide if they will allow hardship withdrawals and under what circumstances they will allow them). Unfortunately, stiff tax penalties apply to those withdrawals. But basically, a cash withdrawal is not something you want to do unless you are at wit’s end. |
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Another option is to take out a loan from your retirement plan. Most plans allow loans for important expenses, such as paying for college or buying a house. And borrowing is easy-as a plan participant, you automatically qualify. There are a number of reasons, however, why borrowing money from your plan should only be done as a last resort:
- Lost Profits–The first reason is that even though the interest you pay on a loan (usually prime plus an additional 1% or 2%) is deposited back into your retirement account, you most likely are losing money over the long term. That’s because the interest you are paying to yourself is usually less than the rate of return you would have earned had you kept that money invested in your retirement plan. In addition some plans won’t let you make contributions until you have paid off your loan—which means you are losing out on the benefits of compound interest (interest earned on an investment that is added to the original amount of the investment).
- Defaulting on the Payments–When you take out a loan on your retirement plan you run the risk of not being able to pay it back. If that happens, the IRS will treat the loan as a distribution and will impose a 10% withdrawal penalty. In addition, you may have to pay income taxes on that distribution.
- Job Loss–If you leave your employer, the plan provider will usually require full repayment of the loan within 60 days of termination of employment. If you don't repay the loan within that time frame, the IRS will consider it a distribution and will assess the 10% penalty and you will be responsible for any income tax on the payment.
- Free Money–And finally, people who are in the process of paying back a loan often find it difficult to continue contributing to their retirement accounts. If that’s the case and your employer offers matching contributions, then you are throwing away free money. You also will be foregoing the advantages of compound interest.
The bottom line is that taking a loan from your retirement plan can be more costly than you think and can seriously undermine your chances of building sufficient retirement savings. Consequently, you only should take out a loan in dire circumstances and only after you have exhausted all other options. Under no circumstance, experts say, should you take money out of your retirement plan to fund a non-essential or discretionary expense.
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