During times of financial hardship people are forced to think – when life hands you lemons, take a loan. We get it! High inflation and a volatile economy are pushing people to think about where they could tap into fast cash if they needed it. A quick search on the internet will show you the most common ways are Credit cards, personal loans, HELOCs and retirement plans. Those first 3 have pretty easy to understand risks. If you don’t pay these loans back then your credit score could suffer or you risk losing your home. But when it comes to taking a loan from your retirement, the risks aren’t so apparent. This typically leads people to say, “The loan from my retirement seems like a no brainer!”. We believe you should think twice about that because these loans are not only risky, but injurious, to your retirement planning.

The reason these retirement loan risks are often overlooked is because much of the adverse effect doesn’t happen for many years. As long-term investment vehicles – 401(k)s, 403(b)s, and 457s give you the ability to invest more aggressively because time in the market will typically yield higher returns. This is where your first major risk comes in. By taking your long-term investment out of the market, through a loan, you’ve now taken away that money’s ability to achieve its full compounding interest potential.

To protect yourself from yourself, you will be required to pay the full amount, plus interest, back to your retirement account. The interest rate is usually 1%-2 over the prime rate and with a term of 3-5 years. While the interest you pay yourself back helps the sting a bit, even if it is going to be double taxed, the major risk remains that you’ve reduced your compounding interest pool of money for years, which has long term ripple effects that you could feel in retirement.

In addition to reducing your current compounding potential, as you strive to repay the loan back, you will most likely need to reduce or suspend your future contributions to the plan. This act of slowing or stopping your savings rate could once again greatly alter your retirement outcome.

One of the largest risks involved has to do with your employment status while paying off the loan. If you leave your job, are laid off or fired, you will typically have to pay off 100% of the remaining balance very quickly.  The deadline for getting this amount back into a qualified account is the following years due date of your federal taxes plus a 6-month extension. While uncommon, some employers may let you continue to pay on the loan through the retirement plan so you would always want to see if that is available.

So, here comes the troubling part of this employment issue. If you cannot pay the full amount off by the deadline, then the IRS will recognize the remaining balance as a taxable distribution. Even worse, if you are under age 55 (rule of 55 for 401(k) and 403(b) plans) then you would be subject to an additional 10% early withdrawal penalty.

You should never confuse your retirement plan with a bank account. In taking these types of loans, you are opening the door to the possibility of not reaching your long-term retirement goals. Why risk that? You should look elsewhere for money such as your own savings account with the goal to replenish over time. If possible, work to create a payment plan or use 0% financing for expenses that would allow it. Check with your local bank on a personal loan to see if rates are favorable. Start a budget to help you not only free up cash flow for current obligations but also to create an emergency fund that could help with future hardships. It’s inevitable that things come up and we must consider our options for fast cash but borrowing from your employer-sponsored retirement plan should be viewed as a last resort.

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