Loans from retirement accounts may be appropriate for short-term need of an emergency or essential item. That means, a necessity that can be paid back in less than one year, though IRS rules allow for any fixed installment usually lasting less than five years.
The longest government shutdown in recent memory ended in January 2019. While much of the news featured photos of public service employees lining up at food banks, another quieter theme emerged: many federal employees were borrowing from their retirement accounts. They did so hoping that they would receive back pay, for the weeks when they weren’t paid, in a lump sum that they could quickly contribute before any tax consequences were incurred.
That quieter theme may have turned a few nongovernmental employees towards retirement accounts. In the battle between an emergency fund (that may be depleted regularly) and saving for retirement, nongovernment employees may have greater appreciation for a retirement account in the post-shutdown world.
How can Plan Sponsors use the news of the use of loans from retirement accounts by government employees as a backstop to unemployment to help employees understand their retirement options? Here are a few key points to borrowing from retirement accounts that employees may need information about.
First, the media and many advisors have sought to keep employees from robbing their 401(k) plans to pay for non-essentials or non-emergencies. And yet, employees keep borrowing from the accounts. According to the Employee Benefits Research Institute, a fifth of all employees with retirement accounts have an outstanding loan against their 401(k) plan. Loans from 401(k) plans make sense in some limited circumstances, like a furlough where back pay is highly anticipated.
In other words, loans from retirement accounts may be appropriate for short-term need of an emergency or essential. That means, a necessity that can be paid back in less than one year, though IRS rules allow for any fixed installment usually lasting less than five years. A loan from your own 401(k) may make more sense than obtaining credit from a payday lender or from a big box store at 20% or more. But one emergency may beget another emergency. So if the fridge unexpectedly dies, and a new one is obtained through a loan from a retirement account, when the fault in the wiring is finally discovered that caused the fridge to catch fire, that money might not be so easily repaired. That same scenario may rise with short-term needs for money based on illness of a spouse.
Employees may also need to know that retirement account loans are of limited amounts. Usually only 50% or up to $50,000 can be borrowed from the retirement account and the account must be brought back to its original state within a year (or however the specific plan dictates). And if the employee separates from the company before the loan is repaid, any portion of the loan that remains outstanding will be taxed as income.
If the need is for a short-term necessity, borrowing from a retirement account may be a better option than securing a loan from another source if the loan terms offered by banks aren’t as favorable. Many banks will have a longer repayment term. First, the interest charged on the loan from the retirement account is repaid to the account, meaning a no loss to the borrower, unlike other loans. And securing the loan won’t require a credit check or other potential ding to the employee’s credit score.
If, in the case of furloughed employees, the loan is of extreme need, IRS regulations may permit a “Hardship Withdrawal.” Under IRS rules, a hardship withdrawal is made on account of an immediate and heavy financial need of the employee, and the amount must be necessary to satisfy the financial need. It is permissible for certain circumstances, including: Prevent eviction or foreclosure of your primary residence; Purchase of a primary residence; Post-secondary education expenses for the next 12 months for you, your spouse, dependents or your children; Funeral expenses; or Expenses to repair damage or to make improvements to your primary residence. A retirement plan will address the specifics of repayment.
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