With the passage of the CARES Act in March, you may have new flexibility to borrow against your retirement plan. But is it the right thing to do? It’s a compelling option at first glance. You borrow the funds tax-free and then repay the loan over time at an interest rate lower than most other sources of credit — about 4% to 5% at current interest rates. Even better is that this interest goes back into your retirement plan. First, we’ll look at CARES Act changes to the loan rules and then consider whether it’s a smart financial move.
With the spread of the coronavirus came personal financial stress for most, whether it was losing a job, having investments decline in value, or suffering through a reduction in pay or hours worked. In response to this, the CARES Act was signed into law that (among other things) increases borrowing limits for many retirement plans. While the 401(k) is the most prevalent plan, the legislation also affects 403(b) plans of nonprofit and state employers, and governmental 457(b) plans.
From now until Sept. 22, eligible plan participants potentially may borrow up to the full balance of their retirement plan or $100,000, whichever is less. Moreover, plans may allow delayed payments on new coronavirus–related loans for one year.
As you might expect, there’s plenty of fine print involved. First, your employer is not forced to change your retirement plan to allow the higher loan amounts. In fact, they may forbid retirement plan loans altogether. So it’s important you check with your employer to understand the loan options of your retirement plan.
Then there’s the matter of eligibility. In order to access the higher loan limit, you need to be a “qualified individual.” This can mean you, your spouse, or dependent has been diagnosed with coronavirus. Other qualifying factors include if you lost your job, had your hours reduced, were furloughed, were forced to leave work to care for dependents, or your business was forced to close or reduce hours. The IRS may announce other qualifications, but right now having a plunging 401(k) is not among them.
Let’s say you’re a qualified individual and your retirement plan permits a loan, should you go through with it? The main objections to retirement plan loans are lower potential investment returns, possibly lowering your contributions, borrowing against your future to pay for your present, and complications if you leave your employer. When you borrow against your retirement plan, investments in your account are sold in order to “invest” in your loan, which from the plan’s perspective earns that 4 to 5% interest (which you will be paying). While stocks have been volatile over the last few months, the S&P 500 outpaces that growth in most years. You could be doing your future retirement dreams a disservice.
When you take out a retirement plan loan, at some point you’ll need to start paying it back and this will usually come out of your paycheck. While you’re paying off your loan, you may find it difficult to keep your retirement plan contributions as high as they were before. Also when you take out a plan loan to pay off say credit cards, you risk having your present lifestyle consume your future savings. Some plan participants take out more than one loan at a time, as they consistently have trouble paying their bills. Moreover if you leave your job, you’ll need to pay back the loan by your tax filing date to avoid having the balance taxed as ordinary income with a possible 10% penalty unless an exception applies. Finally for those who are really hard on their luck, retirement plan balances are largely exempt from seizure under bankruptcy law. But once you’ve borrowed against them, those funds generally become fair game.
There are some circumstances that could call for a retirement plan loan as the best option. In my experience, those cases are rare. While the CARES Act may give you enhanced power to borrow against your retirement, you should think twice before using it.
David Gardner is a certified financial planner practicing in Boulder County. The opinions expressed by the author are his own and are not intended to serve as specific financial, accounting, or tax advice.