Borrowing from a tax-deferred retirement plan such as the TSP or a 401(k) has some advantages. There are no credit checks or lengthy applications to fill out; the plan trustee makes the decision. What’s more, the loan interest goes back into your retirement account rather than to a third-party lender.
In a typical tax-deferred retirement plan, participants owe income tax whenever they take money from the plan as well as a 10 percent penalty tax if they’re under age 59 1/2. Some plans, though, permit borrowing; if so, participants can get at their money, tax-free, and they’ll avoid a penalty tax, provided they follow all the rules.
Plan loans must be made available to all participants and beneficiaries on a reasonably equivalent basis. That doesn’t mean everyone automatically gets a loan. Because the plan must be prudently administered, it must act as a commercial lender would, focusing on each applicant’s creditworthiness. Loans must be adequately secured, typically by the participant’s vested account balance. Many plans require spousal consent for loans, if the employee is married.
The thought of effectively borrowing from yourself and paying yourself back can be enticing but borrowing from a retirement plan has drawbacks, too.
* Tax consequences. Anyone who defaults on a loan will have taxable income from the distribution. Such a default may be triggered whenever the borrower misses an installment payment. The entire outstanding loan balance may become taxable income at that time, so borrowers have to be extremely careful.
If you borrow from a qualified plan, you should arrange to have loan repayments withheld from your paychecks.
If you part from your employer and no longer participate in the plan, you must repay the loan or take the unpaid balance as taxable income.
* Legal hurdles. Another disadvantage of plan loans applies if you borrow to buy a home. The retirement plan will be a lien holder on your personal residence, if the loan is secured by the house.