---

Retirement Plan Loans
by
Randall Bingham

Retirement savings plans are one of the most neglected borrowing options in the country... The loans make sense for debt consolidation, home improvements, vehicle purchases, and tuition. Source: Downsize Your Debt by Andrew Feinberg, Penguin Books

Borrowing from retirement accounts is nothing new. Tax-deferred savings plans sponsored by employers, the most common of which is a 401(k), can allow participants to borrow up to 50 percent of the money in their accounts... Employees pay themselves back with interest at rates often lower than on other loans.
Source: The Orlando Sentinel / New York Times

A five-year TSA loan can be used to help pay off past debts (especially those incurred at high credit-card interest rates) and to pay for any costly emergency needs...
Source: Financial Tips For Teachers by Jay Weiss & Larry Strauss, Lowell House

You need money fast and can get a home equity loan at 8 percent or borrow from your company's 401(k) retirement savings plan at 6.5 percent. Which is the better choice? Borrow from your 401(k), members of the International Association for Financial Planners recommend... When you repay a 401(k) loan, the interest goes to your 401(k). It's always better to pay yourself, members of the IAFP say.
Source: Pensacola News Journal

You can borrow from your own tax-deferred Keogh, 401(k) or 403(b) account, or company profit-sharing plan. You don't need a bank loan officer, so the account can be a source of tax-free cash to pay for college or a down payment on a home- often at a lower rate than you would have to pay at a bank.
Source: Your Money

Most employee savings plans- like the 401(k)- permit you to borrow from them. The top limit is usually 50 percent of your account balance, or $50,000. The interest is almost always lower than what you'd pay elsewhere... and since you're essentially borrowing the money from yourself, you pay the interest owed back to yourself. Source: Family Circle

The first big cost of paying off a debt is the cost of income taxes that must be paid on the earnings you will use to pay the payment. Every payment of a debt is made up of principal and interest. It doesn’t matter whether the loan came from a bank, a relative or your retirement account, you have to pay income tax on the principal cost and the interest cost. Everyone is so conditioned to the fact that the cost of tax is there, that we don’t always factor in that cost. When the interest is at a higher rate making the total payment high, the cost of income taxes paid is also higher. For example, in order to pay a $100 payment, for a person in the 25% tax bracket, a total of $131 must first be earned, income taxes must be paid, then there is $100 left over to make the payment of principal and interest. Lowering the cost of interest can be a way to also reduce the cost of income taxes when excess funds are tax deferred by increasing retirement savings. The key here is whether or not you can choose to defer the income. Debt payments require you to choose to not to defer income since you must spend the money.

The second big cost of paying off a debt is the interest. The total cost of interest is based on both the rate of interest and the ratio of interest compared to principal. For example, a 3% interest rate on a loan can become more expensive than a 5% interest rate loan where the ratio of interest to principal is so high that the loan will take decades to amortize. Credit card companies and mortgage lenders are advertising that you will be able to reduce your payment on an interest only arrangement. Where the interest is 100% of the payment, your interest cost goes on forever. You must increase the size of your principal payment in order to reduce the cost of interest.

The way to get debt paid faster is to lower the rate of interest and to lower the ratio of interest to principal. It is almost universally understood as evidenced by the past decade of refinancing that has taken place. The cost of a loan from a retirement plan is often one of the very lowest cost rates available and at the same time most of the interest paid adds to your own retirement balance. As a move to lower the cost of interest, a loan from a retirement plan could save a person significant amounts.

Many individuals are paying extra principal on their debt to reduce debt faster with extra money in their budget. However, do they consider that paying down of debt is more expensive to the financial net worth when it supersedes the more important task of reducing income taxes? Considering the fact that the average cost of debt is 10% to 14% while the average cost of income taxes is 20% to 40%. When looked at from a cost standpoint, income tax reduction will bring a greater rate of return than any other financial move that can be made, with a guaranteed return. A person should first consider deferring income taxes by building up a retirement account, then using those funds to refinance the debt at lower costs of interest.

The most common reason given for not contributing a substantial amount into a tax deferred retirement plan is that “it is not affordable”. If one were to question further, current lack of cash is not the issue as much as the thought that once placed into a retirement account, funds are not touchable until retirement. For a younger person, that seems like money that is lost and gone forever. Access to the money, in the form of a loan, then is vital to the ability to be able to set money aside into a retirement account. National statistics indicate that teachers, on average, save $200 per month in 403(b) retirement accounts. Once a person is taught about the uses of the loan provision, savings can jump to an astounding $700-800/month, based on my personal experience and that of other PRO Financial representatives I have talked to. Learning to use the loan provision of the retirement plan could increase your rate of savings, because it puts a shorter horizon on the use of the money.

A new client told me that she has set aside $100 a month for some time at little or no interest gain because she wanted some emergency money. I explained that if she had made 403(b) contributions instead, with tax savings added to the balance, she would have been able to gather a larger sum of money by this time. Because the balance was less than $5,000 at her bank, most of the time, she got no interest at all. Right now the amount is small compared to the assumed 3.8% rate inside the 403(b). The 403(b) savings would have been able to accept the pre tax payment amount of $125 a month. Her question back to me was “What if an emergency arises and there is a need to spend $6,000?” My answer was simple. Wouldn’t everybody strive to rebuild an emergency fund once it had to be used? It takes about the same 5 years of payments of $100/mo to rebuild the balance as it would take to payback the retirement plan loan. After the loan is paid back, the individual can again start putting in $125 into the retirement plan pre-tax.

YEAR	Traditional Savings Account	403(b) Account	Difference
5	$6,010	$8,246	$2,236
	$10	$2,246	$2,236
	$6,023	$9,340	$3,340
	$12,342	$19,537	$7,195

In the above example, the person would have survived the emergency and would have over 50% more money by using a retirement account and income tax reduction rather than the traditional savings vehicle as a basic savings vehicle.

Of course, we assumed that the person was able to put all the money back into the retirement fund before the 5 year IRS deadline expired. All funds borrowed from a retirement fund must be paid back in equal installments, either monthly or quarterly, with a repayment schedule that is no longer than 5 years, unless the funds are used to purchase a primary residence and then the repayment schedule can be no longer than 15 years. If the loan is not paid back on time, the entire borrowed amount will be taxed and the early withdrawal penalty of an additional 10% will be added. The greater of $10,000 or 50% of qualified funds, up to $50,000, by tax law, is available for a loan. Some retirement plans may not allow the full amount that is allowed by IRS code.

---

Randall Bingham is executive director of Financial Futures Education Corporation and has taught seminars for corporate groups and individuals about taxes and money management over the last 20 years. He is an independent associate of PRO Financial Group and a registered representative of NASD registered PlanMember Securities Corporation. He is a certified member of the National Association of Mortgage Counselors and is licensed in real estate, insurance and securities. He can be contacted at: r_bingham@profinancial.net