Can I Borrow Against My Retirement Account?

If you’ve got retirement accounts and are in need of quick access to cash, you might be wondering, "Can I borrow against my retirement account?" The answer is complicated. In short, yes, you can.

You'll have to weigh the benefits of borrowing against your retirement account versus any potential risks—which we discuss below. In general, you can borrow from a 401(k) or IRA with an employer plan and take money out without penalty as long as you repay it back within five years.

If you're over 55 years old, then there are additional rules which we also cover briefly, along with how changes last year as part of the CARES Act affected things. This is all good news for you if you need to tap into the account. However, the real question here is, even if you can borrow against your retirement account, should you?

Let’s dive into how to make the right decision and how much it would cost you in withdrawal penalties.

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What Are Normal Retirement Account Withdrawal Penalties?

Under normal circumstances, if you withdraw money from a tax-deferred retirement account before the eligible age, you have to pay a 10% penalty fee. Likewise, you also have to include the amount you withdrew in your taxable income for the year.

While that’s pretty standard, there are, of course, some exceptions. These exceptions include having to borrow from your account due to home repairs caused by a natural disaster and having to cover out-of-pocket medical expenses.

However, it’s important to note that even if you are able to borrow against your account for something unexpected, they usually only allow you to withdraw the exact amount you need. Even then, it’s a process (that can be both time-consuming and headache-inducing).

The CARES Act and 401(k) Accounts

In March of 2020 when the CARES Act was passed as the first coronavirus stimulus package, people with 401(k) accounts became eligible to take out CARES distribution and tap into their retirement accounts early. By mid-April, over 160,000 people had already borrowed against their accounts as the economic crisis worsened.

The IRS created a special page dedicated to questions surrounding the CARES Act and retirement accounts, but here’s what you really need to know. You are eligible to withdraw from your accounts with fewer penalties if you meet a few requirements. Among others, you’re eligible if you were diagnosed with COVID-19 or experienced “adverse financial consequences as a result of being quarantined, being furloughed or laid off, or having work hours reduced” as a result of the pandemic.

So, what are you eligible for exactly under this Act? The IRS states that, “in general, section 2202 of the CARES Act provides for expanded distribution options and favorable tax treatment for up to $100,000 of coronavirus-related distributions from eligible retirement plans (certain employer retirement plans, such as section 401(k) and 403(b) plans, and IRAs) to qualified individuals.”

What this really means is two things:

  • Early withdrawals are counted as taxable income and taxed at ordinary income tax rates.
  • You can choose whether you opt to pay taxes on the distribution over three years or repay the distribution within three years and avoid tax consequences altogether.

So, we’ve answered the question of whether or not you’re able to borrow against your retirement account. Now, it’s time to answer the question of whether or not it’s a good idea, even if you’re in need of the cash.

Should You Borrow Against Your 401(k)?

If you’re doing it for the right reasons, borrowing against your 401(k) can be a good idea. This is often referred to as taking out a 401(k) loan. As the name suggests, you’re basically getting a loan from that retirement account, which is almost like getting a loan from yourself.

So, let’s start off with some of the most basic reasons why it might make sense for you to borrow against your 401(k) instead of trying to access cash in the form of a personal loan. Namely, you’ll get to benefit from:

  • Repayment flexibility
  • Potential benefits once you pay the money back
  • Cost advantages

Sure, it might not be tax-efficient and it might hurt your investment portfolio, but depending on what the market’s looking like, the latter might not really even be an issue.

Kathryn B. Hauer, a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America said, "Let’s face it, in the real world, sometimes people need money. Borrowing from your 401(k) can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loan—or even a more reasonable personal loan. It will cost you less in the long run.”

Calculate the Cost Advantages

Usually, the rules of borrowing against your 401(k) are pretty standard. Receiving a loan is not a taxable event unless the loan limits and repayment rules are violated. It also doesn’t impact your credit score. And, to top it all off, the interest that you’d pay on the loan you take out goes straight back into your account. So, you’re really just transferring money from yourself to your future self.

So, in this context, it makes sense to take out a 401(k) loan whenever you’re:

  1. Going to pay the money back short-term (in a year or less)
  2. The interest you would pay is far less than what you’d pay in interest for a regular personal loan
  3. The cost advantage makes sense

What is cost advantage in this case? Use this formula to help you determine that:

Cost Advantage = Cost of Consumer Loan Interest − Lost Investment Earnings

Aim for a positive cost advantage. If it’s positive, then taking out a 401(k) loan can be helpful.

Should You Borrow Against Your Retirement Account?

The answer to this question is truly dependent on your individual financial situation. If you need access to the cash quickly and plan on repaying it within a year or so then it probably makes sense. This is especially true if the market is weak as it won’t affect your portfolio quite as much long-term.

Overall, borrowing from a retirement account such as your 401(k) is relatively safe financially. And, it’s pretty easy (you can usually complete the process with just a few clicks online). However, you’ll definitely want to take a look at a retirement calculator to figure out how much you’ll owe in the long run. 

Make sure you’re making the right decision and perhaps speak with an investment advisor who will let you know how your withdrawal will affect your investments. If you don’t need that much money, it could be worth looking into getting a small personal loan instead.

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