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Retirement planning is investing in yourself so you can have money after you stop working. The advantage is that you will be able to keep your standard of living after you retire. Moreover, planning for your retirement will empower you to save as much as possible in your retirement account and to not make withdrawals from it.
Even though taking money out of your retirement goes against savings, there are cases that it’s wise to do so. As you continue to read this article, you’ll discover the pros and cons of borrowing money against your retirement.
What Type of Retirement Accounts Can You Borrow From?
It’s possible that your retirement is available for you to borrow against. Trust me… the rates will be more competitive than what you’ll receive at your local bank. Even though borrowing from your 401k is prohibited, it may be lawful to take out a small loan. Moreover, having a 401k plan puts you in position to receive a loan. Keep in mind though that there are restrictions regarding how you can use the money.
Plenty of 401k plans offer loans for those who need one. You have the option to borrow up to ½ of what you have put towards your balance or $50,000 (whichever is lower) at a low-interest rate. The good side about it is that you have up to 5 years to pay back the loan and up to 15 years for a buying a home.
Also, there are companies out there that restrict the loans for a specific purpose such as paying off medical bills or to prevent foreclosure. The company you work for will automatically take the money out of your check and put the principal and interest back into your IRA account.
401k Loan Cautions
Now be aware of this fact… if you lose your job (no matter the reason) you have to pay back the loan within 90 days of termination. Moreover, if you don’t pay it back in time, the lender considers what you owe a withdrawal.
On top of that, you have to pay taxes on that money at the normal tax rate along with a 10% penalty if you are under the age of 59 ½.
Provisions for loans are not associated with IRA accounts. This goes for both traditional and Roth IRA accounts. The law itself established this restriction. Also, it’s not dependant on the trustee of the IRA.
IRA as Collateral
If you decide to give your IRA account as collateral for a loan (which means that bank has the right to withdraw from your account if you don’t pay it back), the IRS considers it a distribution of the entire account balance. Moreover, you may owe taxes and a 10% penalty on the account balance. You will also lose the benefit of having a tax-free compounding of the IRA in the future.
IRA 60-Day Loan
With this option, you have the ability to withdraw from an IRA through committing to pay back the funds within 60 days incurring taxes or penalties. In other words, you’re receiving a short-term interest-free loan. This timeframe also includes weekends as well as holidays. There is no grace period either. Moreover, the replacement funds can go into an account that’s different than the previous one.
Roth IRAs are available to provide you the money that you need. Just keep in mind that you prolong to achieving your retirement goals as well. A major advantage is that you can withdraw without triggering any tax liability. I recommend asking the person who prepares your taxes if this is an option for you.
Loans vs. Withdrawals
Now here’s what you need to know: Making a withdrawal out of your retirement account is different from borrowing against it. They’re similar due to the fact that they decrease the amount you have in your portfolio.
For instance, if you have $100,000 in your retirement account and take out $40,000, the balance remaining is $60,000. The good thing about a withdrawal is that you don’t have to return what you withdrew. However, you have to pay back what you borrow if you decide to get a loan to avoid tax and penalties.
If you decide to get a loan, the amount the lender grants you is an asset in the plan because your promissory note replaces it. Since the amount isn’t diversified, it will receive a rate of return, which has the potential to be the average of the prime rate plus 2%.
In order to have diversity, you have to weigh the risks as well. Moreover, there is a possibility that you will receive a bad return on investment unless some of your investments is promising a guaranteed rate of return. In a nutshell, the positive of taking out a loan from your account is that you will solidify your rate of return on the loan amount.
Borrowing Against Retirement Account – Things To Consider
Here are the most important things to consider when borrowing against your retirement account:
1. Double Taxation
One of the main things people complain about is that the IRS will double tax and charge interest when you borrow against your retirement account.
The reason why is because the loan repayments (including interest) will be made dollar amounts that are previously taxed when withdrawn from a retirement account.
If you don’t pay attention, it possible for you to lose money because of fees. Loan origination fees and annual maintenance fees are a couple of examples.
Moreover, if you take out a $1000 loan and you have to pay a $75 origination fee and a $25 maintenance fee on a 5-year loan, you end up paying $200 in fees or 20%. That’s a lot of extra money to dish out! That’s why it’s important for you to know the fees associated with your plan of choice.
3. Moving Jobs or Being Fired
Here’s a point to keep in mind… if you transition to another loan or lose the one you have, your 401k loan will become due immediately. The good thing about it is that you’ll have a 60-90 day grace period. However, if you can’t pay the loan back in time, you’ll have to pay a 10% penalty and the normal tax rate as you would a normal default.
As a result, you’ll see 35-40% in taxes and penalties. When tax season comes around the corner, you’ll have a huge tax bill waiting for you in a time that’s not desirable!
4. Lost Retirement Gains
When you withdraw against your retirement, you lose the money you would have had if you didn’t. The cost is even greater when the market is downhill. When that happens, you’ll have to wait to see the money return whenever the market is on the rise. Sadly, you lose out on the gains you could have had.