One advantage of employer retirement plans as opposed to IRAs is that some plans permit loans on your retirement assets while you’re actively employed, which may prevent you from incurring a 10 percent penalty — plus ordinary income taxes — on distributions out of retirement programs if you get into a cash crunch.
These plan loans are subject to a few requirements:
- The maximum loan must not exceed the lesser of 50 percent of the vested account balance, or $50,000 Loan amortization cannot exceed five years
- The payment must be made at least on a quarterly basis, but is usually paid by the participant semimonthly through payroll deductions
- You must pay interest on the loan; these rates are usually set at the prime rate, plus 1 or 2 percent
- If you’re married, your spouse typically must also consent to the loan. If the loan is renegotiated during its term, it is considered a new loan. This will usually cause additional problems with either the $50,000 maximum limit or the five-year repayment period requirement. Because of this, many plans prohibit multiple loans at the same time. When these rules aren’t followed or payments aren’t made, the outstanding principal and any unpaid interest on the loan will be deemed a distribution to the borrower and taxed as ordinary income in the year during which the rule(s) is broken. Participants below the age of 59.5 will also be subject to a 10 percent early withdrawal penalty in 401(k) plans but not in 457(b) plans, which are never subject to the 10 percent early withdrawal penalty. Depending on the financial circumstances, a strategic default sometimes makes sense and can be an effective way of “taking a distribution” that would not otherwise be permitted without meeting one of the hardship criteria. Note: This is not a credit default. It is a default on the loan from the plan (to you) and is a tax event only, with no credit reporting. Possible advantages of borrowing from your 457(b):
- Compared to traditional lenders, applying for a plan loan is remarkably quick and easy. Applications can usually be completed online by filling out a form. Once your loan is approved, you will usually have the funds deposited directly into your bank account within days.
- Lower interest rates and paying yourself back can be attractive when in a cash flow crunch, particularly if you’re carrying heavy amounts of credit card debt at high interest rates.
- You’re paying yourself back the interest, instead of a bank or financial institution.
Possible disadvantages of borrowing from a 457(b) plan:
Market movement is a key factor when receiving and adding funds back to your account to pay back your loan. The market goes up and down — it’s cyclical — which, unfortunately, and depending on the timing of when you take out the loan, can work against your long-term goals.
Example: Jane takes out a loan when the market is low. When Jane is ready to pay off her loan, the market is much higher and she is forced to buy investments at the higher price — the opposite of the traditional fundamental investing principal of buying low and selling high. This can severely damage her retirement plan and cost her much more than the value of the loan itself. Jane also missed out on market gains. The reverse is also true but it’s a dangerous gamble, particularly with something as important as your retirement savings.
Example: Jeff takes a $30,000 loan from his 457(b) plan at age 40 and repays the loan when he is 44. The investments inside Jeff’s 401k plan return 7 percent for each of the next four years. Jeff’s missed opportunity cost for not having his $30,000 invested in his 401k plan would be approximately $9,300.
• Time value growth of your money is lost. The impact of this is much more significant earlier in your career than later. For example:
|Age||Loan Amount||Missed Growth|
*Assumes retirement at age 60 and loan fully paid back in five years, an 8 percent average annual rate of return on 457(b) investments and 4 percent interest on the 457(b) loan.
Now, imagine doing this several times over the course of your career — the damage could be substantial!
When should you consider borrowing from your 457(b) plan?
Borrowing from your 457(b) plan typically can be avoided with proactive financial planning and budgeting. However, every once in a while, life throws a few curveballs all at once, which, when we don’t have an adequate emergency fund, can cause debt accumulation at high interest rates. Depending on the circumstances, and when careful planning is done, a loan against your 457(b) can be a wise solution. We encourage you to have a financial plan in place that incorporates not only cash flow planning and debt restructuring but can accurately project your after-tax (net) income in retirement to determine if the loan itself will impact your ability to have a sustainable retirement. Only then can you make an informed decision about whether it might be more prudent to take out a consolidation loan or use home equity at low interest rates; we also might be able to offer a viable alternative.
Establish a plan
Financial planning is not all about your retirement income. Don’t wait until just before your retirement to meet with a fiduciary — a professional who is legally, morally and ethically obligated to act in your best interests and not “sell” you financial products that are self-serving.
Find someone you can partner with to guide you through life’s milestones: buying a home, raising a family, education planning, budgeting adequate cash flow, protecting your family’s income and assets and making major purchase decisions.
We have helped hundreds of your peers build financially successful, stress-free (or stress-reduced) lives and given them financial peace of mind by providing clarity and communicating about finances in a simplistic manner.
It’s time for you to take action.