A retirement plan may seem like a good source of funding if you are running short on cash. Some retirement plans offer loans, which lets you access the funds without taking a permanent withdrawal. Though you do not have to worry about being approved for the loan, retirement-plan loans are not without risk.
Eligible Retirement Plans
Not all retirement plans permit loans. You cannot borrow from an IRA at any time; doing so disqualifies the IRA. Only 401(k) plans, 403(b) plans and government plans can allow loans. However, the IRS does not force these plans to allow loans. Before making plans for how you will use the loan proceeds, ask your retirement-plan administrator if your plan allows for loans.
The maximum that you can borrow from your retirement plan equals $50,000 or 50 percent of your vested account balance. The vested account balance equals the amount you could keep if you left the company. For example, if your vested account balance equals $60,000, you could not borrow more then $30,000 because $30,000 is smaller than $50,000. However, if your vested account balance equals $150,000, your borrowing limit equals $50,000 because $50,000 is smaller than $75,000, 50 percent of the balance.
In general, you have to repay your loan within five years of taking it out. If you use it to purchase your home, you can take longer. The IRS requires you make at least quarterly payments, but some employers allow you to use payroll deductions to make the repayments. You also have to pay interest on the loan, typically a point or two above the prime rate. Unlike a loan from a bank, however, the interest you pay goes back into your qualified retirement plan instead of being paid to the bank.
Failing to Repay Loans
The danger of taking a retirement-plan loan is that the IRS considers it a distribution if you cannot repay the loan as agreed under the terms of your loan. If you are under 59 1/2 years old when you default on your retirement plan loan, not only do you owe income taxes but also a 10 percent early withdrawal penalty. The most problematic situation is if you leave your job or get fired: the remaining balance on your loan must be paid immediately or you default on the loan.
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