The Internal Revenue Service (IRS) allows some, but not all, qualified retirement plans to let participants borrow money from their accounts. Knowing which retirement accounts can permit loans and how those loans function helps you to make educated decisions about whether to use your retirement nest egg for funds.
The IRS permits employer plans like 401k plans, 403b plans and government plans to offer loans. However, even though the IRS permits loans, your particular plan may not. For example, your employer may elect to not allow loans from its 401k plan. You cannot take a loan or otherwise borrow money from any type of individual retirement account (IRA), such as a traditional IRA, Roth IRA, SIMPLE IRA or SEP IRA -- though there are alternative methods of removing cash from these plans for short-term purposes.
The IRS limits the amount that you can borrow from your retirement plan to the smaller of half your vested retirement plan balance or $50,000. However, if half your vested retirement plan is less than $10,000, you can borrow up to $10,000 from your plan. For example, if your vested account balance equals $15,000, half your vested account equals $7,500, but you can still take out up to $10,000. Alternatively, if your vested account balance equals $250,000, you cannot borrow more than $50,000.
Typically, you must repay your loan within five years unless you use the loan for your home, in which case you can take a longer period of time. You may be able to sign up to have your employer automatically withhold money from your paychecks to make your payments. When you make your repayments, the money, including the interest you pay, goes back into your retirement account, so you basically pay yourself back for the returns your money would have earned if it were in your 401k plan.
Penalties for Defaults
If you default on a loan from your retirement account, the IRS treats it as if you had withdrawing the outstanding balance of the account. If you are under 59 1/2 at the time you default, the IRS considers it a nonqualified distribution, which means that not only do you have to pay income taxes on the distribution, but you also have to pay a 10 percent early withdrawal penalty.