5 Reasons not to take out a loan against your workplace retirement plan

When you’re in a financial bind, taking out a loan against your workplace retirement plan may seem like a plausible option. Although you’re able to borrow against your retirement account in many cases, it’s far from an ideal financing source. The risks that may come as a result are steep — some of which may even set back your retirement planning if you can’t keep up with payments.

Borrowing against retirement may be a short-term fix with significant, negative long-term consequences. In most cases, a variety of other borrowing options are available and may not come with the same possible financial consequences. Understanding the reasons not to take out a loan against your workplace retirement plan is an important step for securing your financial future.

Borrowing against your retirement account for the wrong reasons

The temptation to pull from your retirement account to finance a purchase may be high: after all, it may appear that the money is just sitting in the account and doing very little compared to what you have to spend on bills and major purchases. This couldn’t be further from the truth, however.

There are any number of reasons why you might want or need to access money quickly. In almost every case, borrowing against your retirement account should be the option of last resort. Pulling from your retirement investments may set you back significantly in the long run, diverting long-term assets for short-term goals. If accessing cash quickly is pivotal, be certain that you’ve explored all possible alternatives before tapping into retirement money

Repaying your loan in full if you leave your employer

You may only be able to maintain your loan so long as you remain with your employer. These days people are inclined to job-swap, and doing so might put you in a financial bind if you’ve borrowed against your retirement account.

Whether you leave your job voluntarily or involuntarily, your employer may expect for you to pay off the money you’ve borrowed from your retirement account. Failure to pay back your loan in full may create tax penalties* and tax liabilities.

Default penalties can be steep

Defaulting on a plan loan may come with penalties. Not being able to repay what you’ve invested in a tax-advantaged account and being under the age of 59½ means possibly incurring penalties* from the IRS.

Some employers may give you a grace period before the loan has to be settled. If you do not or cannot pay back the loan at this point, the plan administrator will deem you to be in default. This does not alleviate your requirement to pay the loan off, but will result in the untaxed loan amount plus accrued interest being taxed, as well as potentially penalized*. In addition, the loan will continue to accrue interest until it is either paid off or it is offset when you encounter a distributable event as set forth in the plan's loan policy.

Lost time in your tax-advantaged account

The more money in your account, the more there is to invest. If you take thousands of dollars out of your account as a loan, that money isn’t growing and can be viewed as opportunity cost. This may mean losing out on substantial funds in retirement, when you will likely need money the most.

Ideally speaking, retirement accounts grow in value two ways: from your steady contributions as well as from the dividends and gains made on your investments. When your investments pay dividends, they’re reinvested into your account. This money is then reinvested where it may continue to generate more money. When you borrow against your retirement account, you have to pay back your loan total plus interest. This means losing out on potential money that could have been earned and even potentially owing more than you would have earned.

There are other, better options available in most cases

A loan against your retirement account shouldn’t be your first thought. Rather, this option is the loan of last resort. There are other options out there to help you finance your goals or to handle emergencies.

If you’re a homeowner, you may want to explore a home equity line of credit, or HELOC. HELOCs allow you to borrow against the value of your home to help pay for any number of expenses, not just home improvements or repairs. Your HELOC lender will provide you with a set amount of money you can borrow from during a period of time. You can borrow a little or the entire amount of money as often as you like, so long as you pay interest on your balance and your entire balance is paid off by the end of the line of credit’s term.

A second mortgage is another option for property owners. With a second mortgage, you’ll receive the entire loan amount as one lump-sum payment. That means paying interest on the money you’ve borrowed right away, versus paying interest only on what’s borrowed with a HELOC.

You may also be able to take out a personal loan depending on your credit history and credit score. These loans also provide you with lump-sum payouts in exchange for set repayments of the principal, plus interest. Loan terms and interest rates may vary between lenders, loan options, and your own creditworthiness.

There is, of course, the option to finance expenses by way of a credit card. Interest rates are typically much higher with credit cards than loans, so this may not be the ideal financing solution for large balances that have to be paid off over time.

Conclusion

When you need to access cash quickly, pulling from your own retirement funds may seem like a worthwhile idea to consider. After all, it’s your own money you’re borrowing against.

However, the downsides to doing this often outweigh the positives: you can expect to pay hefty income taxes and withdrawal penalties* if you’re not able to keep up with payments. Plus, you run the risk of setting yourself back from reaching retirement goals.

Finding the right financial solution to help you get the money you need can be challenging. That’s why it’s crucial to do your research and consider working with a financial professional to help you assess your options.