Strategies for borrowing from a 401(k) or TSP accounts

Unexpected expenses like a major car repair or hospital bill can be a major financial hit. 58% of Americans report living paycheck to paycheck, according to the CNBC Your Money Financial Confidence Survey Opens in a New Window.‍ ‍ ^{See note 1} It can be stressful to think about how to pay for these unforeseen costs. When financial difficulties arise, what are your options? There are some pros and cons of turning to your 401(k) or TSP that you want to weigh based on your personal financial and tax situation. Here are some of the most important to consider.

What other sources of funds do I have?

In addition to your retirement accounts, you may have other funds you can tap. To smooth out life’s financial road bumps, build an emergency fund. You may also consider a small personal loan. You might be tempted to use a credit card. While that may seem like an easy solution, high interest rates can also make it a costly one. Remember that balance rolls over month after month. In other words, consider all sources available to you before turning to retirement accounts.

What is the purpose of a 401(k) or TSP?

Let’s get a quick refresher on purpose and tax benefits as you consider taking a loan from your retirement plan. The purpose of your 401(k) or TSP, also known as qualified plans, is for your retirement. Their purpose sounds simple enough, but it’s important: What you save for retirement is what will provide for your living expenses after you stop working, along with any pension income like Social Security or military retirement.

The tax advantages on 401(k), TSP and 403(b) plans serve as encouragement to help you to save for retirement. In exchange for these advantages, there are also limitations and penalties when they’re not used for their intended purpose.

Advantages of 401(k) and TSP plans

Both 401(k) and TSP plans can come in Roth and traditional versions. The difference lies in tax treatment. Check out this article to learn more about the differences between Roth and traditional accounts.

Another advantage: Your employer might match your contributions to your retirement plan. Some view matching contributions as a way to attract and retain talented employees. The Department of Defense also matches contributions to a TSP under the Blended Retirement System. Think of these matching contributions as free money — and a valuable way to help you achieve your long-term retirement goals.

Disadvantages and limitations

Since the government provides tax advantages for retirement, there are some limitations on when you can access that money. In general, that age is 59.5. If you withdraw funds from a traditional qualified plan or the earnings of a Roth-qualified plan without a qualifying exception before age 59.5, you will face a 10% early withdrawal penalty and must pay taxes on that money.

But there are exceptions that would allow you to withdraw the money early and penalty-free. To see if you qualify, check with the IRS Opens in a New Window.‍ ‍ ^{See note 1} You can access your Roth contributions at any time since you didn’t get a tax deduction for those.

Borrowing versus withdrawing from a 401(k) or TSP

If you decide to use money from your qualified plan, it’s important to understand the distinction between withdrawing the money and borrowing it. When you withdraw money, you have no intention of paying it back. You’ll have to pay any taxes or penalties that come with taking out the money. When you borrow from your retirement plan, you won’t face taxes or fees unless you don’t pay it back.

You can borrow from a qualified plan but you can’t take a loan from an individual retirement account like a Roth IRA or traditional IRA. Not all employer plans offer loans, and they aren’t required to do so. Make sure to check what’s allowed with yours.

It’s also important to remember that when you talk about “borrowing” from your qualified plan, it’s actually a loan from yourself — and just like any other loan, it needs to be repaid. If you don’t, the IRS will treat it as a withdrawal from your retirement plan. You’ll owe the taxes and penalties that might be due.

For example, if you borrow $5,000 from your 401(k) but only repay $2,000, the IRS will treat the remaining $3,000 as a distribution subject to the rules that apply at the time of withdrawal.

It’s possible to withdraw money from a qualified plan and not pay a penalty, if it qualifies as a hardship distribution. The plan provider isn’t required to offer this option. But if they do, it must meet IRS guidance Opens in a New Window.‍ ‍ ^{See note 1}

How much can I borrow from my 401(k)?

The maximum amount the IRS allows to be borrowed from a qualified plan is 50% of the vested balance or $50,000, whichever is less. If 50% of the vested balance is less than $10,000, the owner can borrow $10,000. But your plan might also have a minimum, sometimes as little as $1,000.

For example: If you have a vested account balance of $40,000, you could borrow $20,000. If the vested account balance is $15,000, you could borrow $10,000.

There are additional rules for how much you can borrow if you’re taking more than one loan out at one time. Make sure you understand which set of rules applies to you.

Will I have to pay interest?

Loans have interest rates. This applies to a qualified plan loans as well. So, if you borrow from your retirement plan, you’ll pay back the amount of the loan plus interest. The good news? This interest is paid back into your account — in other words, you’re paying yourself to borrow money from yourself.

You can check with your plan to see what the interest rate will be. For example, TSP accounts charge the same interest rate as what is offered by the G Fund the month before you take out the loan. As I’m writing this, that rate is 4.750%, which is reasonable but can change at any time. You can check the current TSP loan rate Opens in a New Window.‍ ‍ ^{See note 1}

Looking up the TPS interest rate got me wondering what the interest rate would be if I were to take out a loan from my 401(K) at USAA. The current interest rate for that loan is 9.25%. You can see why I said the TSP loan rate was reasonable.

How long do I have to pay back the loan?

In general, you have five years to pay back a loan from your retirement account. If you’re using the loan for a primary residence, that timeframe may be extended. For example, the TSP caps a general purpose loan at five years, but a primary resident loan can be extended up to 15 years.

But what if you leave your employer, whether by choice or not, before you repay the loan? You no longer have five years. Instead, you must repay the loan by the due date of your federal income tax return, including any filing extensions. If you’d planned on a longer repayment schedule, you might be unpleasantly surprised by this unexpected bill coming due.

Pros of borrowing from 401(k) or TSP

Availability

Your retirement account is a source of funds that’s available to you. While it might not be the ideal solution, it could be better than going into credit card debt or pursuing a payday loan. It’s definitely better than going hungry or losing a home to foreclosure.

Interest savings

You'll pay interest on a loan from your 401(k) or TSP, but you’ll be paying back that interest to yourself. Plus, the interest rate may be significantly lower than what you might pay for a personal loan or on a credit card.

Speed

Borrowing from your retirement account can be a quick way to access funds. It may take just a matter of days.

Cons of borrowing from 401(k) or TSP

Delayed retirement savings

Each qualified plan can have different rules, but during the time the loan is outstanding, your employer might not allow you to contribute to your account. That also means you might miss out on employer matching contributions during that time. This can put you behind on achieving your retirement goals.

Potential for missed earnings

Borrowed money from your 401(k) means that money isn’t invested in the market, which could mean you miss out on any market gains during the loan timeframe. But if the market declines during this time, it might actually turn out for the better. We just never know.

Taxes and penalties

If you don’t pay back the loan, it will be treated as a withdrawal from your retirement account.

The best advice is to have a robust emergency fund to help provide a cushion when life’s difficulties hit. But life can throw an occasional curveball that even Babe Ruth could not hit. In those situations, borrowing from a qualified plan might be a good option to help you get back on track financially, but review these following key points before pulling the trigger.

• Be honest with yourself and figure out how you got into this position in the first place.
• Seek financial advice from a reputable source to review your overall situation, explore all other options, create a budget and develop a debt repayment plan.
• Consider consolidating debt into a lower interest rate or doing a balance transfer on credit card debts.
• Contact your creditors directly to discuss alternative payment options or speak with a consumer credit counseling agency.