Taking a Hard Look at 401(k) Loans and IRA Withdrawals

Last Thursday, I dodged out of the office for a bit to grab a bite to eat at the Pickle Jar on Main Street in Falmouth. I like the place; I really do. The food is fantastic, and the owners and staff are always friendly.

Anyway, as I was sitting at the lunch counter waiting for my toast and their famous homemade hash, a very nice man sat next to me and we got to talking. John is about my age, from Falmouth, married, with 3 kids gearing up for college. He and I are in pretty much the same situation since we both have our first kid going off to college next year. I can certainly appreciate John’s nervousness since both of us are staring down the barrel of three college tuitions. After discussing various ways to pay for tuition, John asked me about my feelings on taking a loan against his 401k to help pay tuition.

Hmmm . . . let’s think about this.

You see, retirement savings should be just that – exclusive savings for retirement. Accounts like 401(k) plans and IRAs are the backbone of most Americans’ retirement savings. With proper planning and an appropriate investment strategy, these accounts should grow; earning interest and returns to help provide the safety and security we all will need in retirement.

I find that borrowing or withdrawing from one’s retirement savings is rarely advisable. Since these investment vehicles provide tax advantages, the IRS makes it difficult for folks to use them as traditional savings accounts. But, sometimes your back is against a wall, and you have no choice. If you find yourself in this situation, take solace in the knowledge that you are not alone. In fact, according to the Society for Human Resources Management, about one-third of Americans borrow from their retirement plans at some point in their lives.

So, today I thought we’d use our time together to take a look at two common ways folks dip into their retirement savings, so we can get a better understanding of the positives, negatives, and potential repercussions. We’ll focus on 401(k) loans and early distributions from IRA plans.

Let’s start with 401(k) plans.

To start, always discuss your company’s 401(k) plan terms and conditions with your HR department or the plan administrator.

While most early withdrawals from a 401(k) plan are taxed as ordinary income and incur a 10% penalty fee, there are exceptions – such as in the case of a disability, a Qualified Domestic Relations Order (QDRO) after a divorce, or death. But, assuming these exceptions are not applicable, what then? One option is borrowing, rather than withdrawing, from your 401(k).

A 401(k) loan would help you avoid the early withdrawal penalty and associated costs. The IRS allows you to borrow up to half the vested balance of your 401(k) account OR $50,000 (whichever is less). While you will incur some fees, there is no credit check. And, you pay yourself back with interest, which may cover some of the interest it would have accrued if you didn’t take the loan.

Typically, you can repay your account for up to five years; some employers provide an extended period if you used the loan as the down payment on your home. And, if you borrow more than you need, or find circumstances have changed, some employers will allow you to reimburse your account without incurring a pre-payment penalty. Again, it depends on your company.

Now . . . the downside.

First, not all businesses offer their 401(k) enrollees the loan option. You’re more likely to see this at larger companies than at smaller ones.

Next, if you leave your job or are terminated, you may have to pay the loan back in its entirety within 60 days. Otherwise, your loan balance is treated as ordinary income, and you’ll get hit with the 10% withdrawal penalty. This is not the outcome we are looking for.

Last but not least, keep in mind that the money you pay the loan back with ends up taxed twice; because you’ve already paid taxes on the money you’re repaying the tax-deferred account with. So, when you finally take a distribution, you’ll end up paying taxes again.

Let’s look at IRA accounts and see how they compare.

First off, you are not permitted to borrow from your IRA. There’s no IRA loan mechanism, as there is with some 401(k) plans. IRA’s are not inflexible, however.

The IRS permits you to take penalty-free IRA distributions to pay for some higher education expenses at approved colleges for you, your spouse, child, or grandchild. Bear in mind that this money counts as income, making it a critical consideration for families relying on Federal aid to help pay for school. An IRA distribution must be reported as income when you apply for Federal aid the following year, so it may hurt your ability to qualify for aid later. Whereas money held in IRAs is exempt and does not need reporting as part of the government’s consideration for the FAFSA.

Finally, any money you withdraw from your IRA will lose the tax-deferred investment growth you would have experienced had you left the money in your IRA.

Roth IRA’s are handled a bit differently, since Roth IRAs are funded with after-tax dollars. The IRS enables you to withdraw from your Roth IRA without paying penalties, as long as you only withdraw what you’ve contributed. So, if you’ve contributed $50,000 to a Roth IRA, which now has a balance of $75,000, you may borrow up to $50,000 without any tax liabilities. Bear in mind, the IRA must have been established five years or more from the date you make that first withdrawal.

Folks, borrowing money or early distributions from your retirement savings should be a last resort. Your money will best work for you when it’s part of a sound investment strategy, earning interest and growing. As I explained to John, be aware of the drawbacks and limitations of such a move beforehand, and work closely with experts you trust to help you make the right decision.

I really enjoyed my lunch with John; he’s a good guy. Heck, he even picked up the check!

Be vigilant and stay alert, because you deserve more.

Have a great week!

Jeff Cutter, CPA/PFS is President of Cutter Financial Group, LLC, a wealth management firm with offices in Falmouth, Duxbury, and Mansfield. Jeff can be reached at jeff@cutterfinancialgroup.com.

Cutter Financial Group LLC (“Cutter Financial”) is a SEC Registered Investment Advisor.

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