Can You Take a Loan Against an IRA?
Rules surrounding Individual Retirement Accounts (IRAs) are made by the Internal Revenue Service (IRS), and they do not allow taking loans. This means that you cannot directly borrow against your IRA savings, but you can take advantage of the 60-day rollover rule if your financial needs are short-term. The 60-day rollover rule says you can withdraw funds without penalty as long as you repay the money back to the IRA by the end of the 60-days.
For sudden and/or urgent financial situations this can provide temporary relief, but the consequences of not returning the funds on time can be harsh - every penny of the early withdrawal would be treated as a taxable distribution. That means you'd owe regular income tax and an early withdrawal penalty if you're under the age of 59½.
Can You Take a Loan Against Your 401(k)?
Many 401(k) plans do offer the option to take out loans which can potentially give you an accessible source of funds if and when you need them. Sometimes these loans are called Hardship Loans. It's important to note that not all plans allow loans, and there are limits to what you can take. Normally this means you can borrow a loan amount of up to $50,000 or 50% of your vested account balance - whichever is less - at a competitive interest rate. You'd then have between 1-5 years for loan repayment to make sure the loan balance is returned to your retirement fund.
Now, if you don't pay back the outstanding loan amount on time, the outstanding balance would be treated as an early distribution incurring regular income tax. If you're under 59½, you could also face an early withdrawal penalty. This is why borrowing against your retirement funds with a hardship loan is often a last resort.
Pros and Cons of Hardship Loans
Pros:
- No credit checks. A big advantage of hardship loans is that you don't need to worry about your credit score, and those with lower scores or limited credit history can access funds without the usual barriers posed by traditional lenders.
- Lower interest rates. Hardship loans often come with lower interest rates compared to personal loans or credit cards, making them a far more cost-effective option for accessing funds during financial hardships.
- Borrow from your own savings. Borrowing against your retirement fund uses your own money, which means you aren't accessing any new debt from external lenders.
Cons:
- Risk of losing funds. A drawback of hardship loans is the risk of losing valuable retirement savings and the compounding interest associated with those funds. Missing out on these can hinder your long-term financial growth and your retirement security.
- Possible tax implications. If you fail to repay the loan within the specified timeframe, you could face harmful tax implications where the balance is treated as a taxable distribution.
- Impact on financial goals. Hardship loans can have a negative impact on your long-term financial goals and overall financial planning strategy. Borrowing against your savings can disrupt their growth and delay your achievement of future financial objectives.
How Do You Take a Loan on Your 401(k)?
If you wish to take a loan from your 401(k), there are several key steps to take in order to ensure eligibility and compliance with your plan's rules.
Step 1: Confirm your eligibility. Verify if your specific 401(k) plan allows loans and what the loan terms are, as this feature varies by plan. This step is crucial for determining your borrowing options.
Step 2: Contact your plan administrator. Reach out to your plan administrator to start the loan application process so they can provide guidance and the necessary forms that are specific to your plan.
Step 3: Complete your application. Fill out the required loan application paperwork provided by your plan administrator and make sure that all information is accurate and complete so you can avoid unnecessary delays.
Step 4: Provide documentation. Submit any required paperwork along with your application such as a statement of financial need for the hardship withdrawal loan or other documentation that justifies your loan request and demonstrates your eligibility.
Step 5: Approval. Wait for your application to be reviewed, processed, and approved by your plan administrator. This may take some time depending on the plan's policies and procedures.
Step 6: Loan disbursement. Once you've been approved, the funds will usually be deposited into your bank account as a lump sum - so be aware of any processing fees that might apply during the transaction.
Alternatives to Borrowing from Retirement Accounts
Personal Loans
The use of unsecured personal loans is a viable alternative to borrowing from your retirement account. These loans would allow you to access funds without the need for collateral and are based on your creditworthiness, income, and loan repayment ability. That said, you could consider the impact of a higher interest rate during the borrowing period.
Credit Cards
Credit cards can provide convenient financial relief for the short term, allowing you to deal with emergencies or other unexpected expenses without delay. There are often numerous benefits such as cash-back rewards and travel points, but the high interest rates shouldn't be taken lightly, nor should the potential cycle of debt that comes with heavy reliance on credit cards.
Home Equity Line of Credit (HELOC)
If you own a home, a HELOC can provide you with a flexible way to access the cash you need by borrowing against the equity of your primary residence. This gives you revolving credit similar to a credit card and allows you to withdraw up to a predetermined limit (often up to 80%-85% of your equity) for a draw period of around ten years.
Tax Implications of Borrowing from Retirement Accounts
Withdrawals from traditional retirement accounts like 401(k)s and IRAs are taxed as ordinary income, so it's important to understand the tax implications involved with borrowing funds. If you don't repay a loan on time, the extra taxable income gets added to your total annual income on your tax return which could push you into a higher tax bracket. You may also be on the hook for the 10% early withdrawal tax penalty on top of regular income tax if you're under the age of 59½. This is why a Roth IRA is a more favorable option, as contributions are made with after-tax dollars and can be withdrawn tax-free at any time (if you're at least 59½ and made your first contribution to your Roth IRA at least 5 years ago).
