Asking your future self for a loan

Posted by Cindy Wilson.
If you’re rich in retirement savings but cash poor, you may have considered taking a short-term loan on your 403(b)—and then thought better of it.
It may surprise you, then, to discover just how many cash-strapped employees do borrow from their retirement accounts: Among eligible participants, around one in five people have an outstanding loan on their 401(k) plan.1 I would guess that their nonprofit twin sister, the 403(b) loan, is just as popular.
Under certain circumstances, a 403(b) loan can be the lesser of many evils—the worst of which is a premature withdrawal.

403(b) loans vs. early withdrawals

Full disclosure: A couple of decades ago, I relocated for work—and although I had plenty of retirement savings, I didn’t have an established emergency fund. So, I took a $10k distribution from my IRA to use towards the purchase of a condo—which continued to grow in value until it was sold. I would not have borrowed that money to, say, travel the world.
Generally speaking, though, the difference between a loan and a withdrawal is a bit like the difference between visiting your future self to nicely ask if you can borrow ten dollars—and smashing open her cookie jar, without bothering to clean up the mess.
With an early withdrawal, you’ll not only lose the deferred earnings that money could have made, but it will trigger immediate income taxes—including 20% federal withholding as well as possible state taxes—and likely a 10% penalty on top.
With a loan, the understanding is that you will pay it all back, eventually restoring your balance to its original state. The cost to you (as with any loan) is the interest accumulated. You’re also paying an opportunity cost: You’ll lose any potential earnings that the borrowed amount would have made had it stayed inside your 403(b).

403(b) vs. other loans

Let me say straight off the bat: Loans should be avoided—except where they are unavoidable (student loans and mortgages being the best examples). Unfortunately, a sizeable number of borrowers default on their loans, because they overestimate how easy it will be to pay them back, or because they lose their job and need to pay everything back in a hurry.
I would bet that most of that 20% of 401(k) borrowers (numbering the millions) weren’t in desperate need of those 401(k) funds. In my experience, people are using funds from their 403(b) or 401(k) simply to maintain the lifestyle to which they’ve become accustomed—or think they need. Before even thinking about a loan—of any kind—we should consider adjusting our standard of living, or properly redefine “needs” (that new car, kitchen) as wants. And you can’t always get what you want.
However, when that hurricane does come and lay waste to the roof over your head, a 403(b) loan could be your least expensive, most convenient way to come up with the money you need (assuming your employer plan allows for it). In reality, you are borrowing money that is essentially yours to begin with, so it isn’t a loan in the normal sense, but rather a kind of special access pass to a portion of your retirement account on a tax-free basis (generally, no more than 50% of your account balance or $50,000—whichever is the lesser). And on a positive note, the interest rate is typically lower than anything you would find elsewhere, and your credit rating is not a factor when applying.
With most 403(b) plans, there’s a five-year repayment schedule, although in most cases, you can pay the loan back sooner. Check your specific plan rules. Also, you can use a 403(b) for the purchase of a primary residence, in which case you can pay the loan back over a longer period than five years.
Important caveat: If you leave your job while still owing money on your loan, you may be able to repay using the same schedule or you may need to repay it in full, within a grace period of around 60 to 90 days, before you can roll your balance to an IRA or new employer plan. Otherwise, the outstanding balance will be considered taxable, and you may face a 10% early withdrawal penalty. Check the repayment requirements for your specific employer plan.
Bottom line: For more flexibility, the best plan is to have adequate, liquid emergency savings. But as a quick-fix solution, an in-plan loan may work in your favor—as long as you repay it on time, and stay on track with your savings goals.
1 Employee Benefit Research Institute, “Many Have Access to 401(k) Loans, Few Have Outstanding Balances,”,, January 16, 2014
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February 26, 2016