During my years as a financial advisor and retirement planning consultant, one of the most common complaints I received from people was about being able to take money out of their employer-sponsored retirement plans such as a 401k or 403b. For more on what the 403b is check this out. They insisted that it’s their money so they should be free to do with it what they want. And while it is their money and it’s understandable some people would like to access it at any time, they need to realize that retirement plans such as these come with a number of rules and regulations since they are tax-advantaged accounts tied into the IRS tax code and not just a savings account at the bank.
So, what do you do if you want to take money out of your 403b plan? If you’re retired, that’s simple. You just make a withdrawal. But if you’re still actively employed by the company offering the 403b, your options are limited. In most cases, if it’s a qualified hardship you may be able to make a hardship withdrawal. But in most cases if you’re under age 59.5, you simply aren’t allowed to take a distribution, even if you’re willing to pay the taxes and penalties. Fortunately, this is where a 403b loan comes in, check this out for information on the 401k loan.
While not often advertised, many, if not most 403b plans, offer a loan provision. This allows you to essentially borrow money from yourself, at an attractive interest rate, which you then pay back to yourself over time. It still may not be the best choice in a time of need, but it’s worth checking into if you’re in a bind.
403b Loan Basics
- Most plans have a minimum loan amount which can be anywhere from a few hundred dollars up to a thousand.
- Most plans generally allow you to borrow up to 50% of your vested balance, up to $50,000. Keep in mind that not all plans will allow you to borrow from the vested company match and it may restrict you to your personal vested balance.
- Personal loans have a maximum repayment term of five years, but most plans also allow home loans to be taken for the purchase of a new primary residence. Additional documentation may be required to prove the home purchase, but those loans generally have up to a 15-year term.
- In most cases your loan must be paid with equal installments taken directly from your paycheck over the life of the loan. Once the loan has been issued you usually can’t change the payment terms, although some plans do allow you to pay off the loan in full early.
- The interest rate is often set as the prime rate plus 1%. The loans use a fixed rate and will be set on the day the loan is issued.
- Loan origination fees may exist and you can expect to pay anywhere from $25 to $100 just to process the loan.
- Loans proceeds are not taxed at the time of the distribution, but would be taxed in the event of a default.
Advantages of a 403b Loan
Tapping into your retirement nest egg early may seem like a bad idea, but there are some cases where it may be a decent option. For one, if you are faced with a short-term financial crisis and your options are limited to taking out a hefty high-interest credit card balance or pulling some money out of your 403b, which you then pay back over a few years, obviously a 403b loan isn’t going to be too bad compared to paying 12-30 percent on a credit card.
Not only that, but usually you can get the money quickly. You may find that getting your 403b loan processed takes little more than a few clicks online and the money gets deposited into your checking account in a matter of days. In addition, there are no monthly payments to worry about, missed payments, late fees, etc. As soon as you take out the loan your HR department will adjust payroll so that the loan payments come directly out of your paycheck.
And finally, when it comes to paying interest on the loan, you’re actually paying yourself the interest. Sure, the interest portion of each payment is with after tax money, but with such a low interest rate it’s still far better than paying interest on a credit card or payday loan.
Disadvantages of a 403b Loan
As I pointed out, taking money out of your nest egg isn’t usually a great idea. You’ve worked hard to build up that retirement savings and tapping into it early will set you back. There’s no way around that. But there are a few other pitfalls to taking out a 403b loan.
- Fees. These loans usually aren’t free, and as mentioned above there is typically a loan origination fee of anywhere up to $100. In addition, there may be an annual maintenance fee. If you are borrowing $1,000 and they charge you a $75 origination fee that’s 7.5% of the loan. If there’s an additional $25 annual maintenance fee and you require three years to repay the loan you just spent another 7.5%. That $1,000 loan that seemed like a good idea actually cost you $150 in fees, or 15%.
- If you default on your loan it won’t hurt your credit score, but it could be even more damaging to your finances. Defaults are treated as a distribution, which means your money is then taxed and you must also pay the 10% early withdrawal penalty if you’re under age 59.5. If you already spent the loan proceeds and wasn’t planning on having a major taxable event this could lead to big problems come tax time.
- There’s also an opportunity cost when taking a loan. If you pull money out of your retirement account, you’re pulling money out of the market and/or safe fixed accounts as well as temporarily eliminating the tax-deferred growth that money would have otherwise been earning. This essentially puts your retirement savings on hold while you’re repaying the loan.
- The market can also move between when you take a loan and when you repay it. If you’re unfortunate enough to take a loan while the market is at a bottom and then begins going back up you’ve done even more damage to your retirement account as you’ve cashed out some money at a low point and will be buying back in over the coming years while the market is likely rising, or at least higher than it was when you took the loan. Of course the opposite is also true, but nobody can predict the future, so it’s as good as gambling.
- You are also repaying part of the loan with money that has already been taxed. As you know, one of the benefits of contributing to a 403b is the fact that the money is invested pre-tax. When you take a loan you aren’t taxed on the proceeds, but the money used to repay the loan has already been taxed so your additional interest going into the account will effectively be taxed twice–at the time of contribution and again when eventually withdrawn from the account in retirement.
Should You Take a 403b Loan?
Even if your 403b plan allows it, take a moment to consider your options before going for the easy money. It takes a lot of money to retire comfortably these days, especially with the dim prospects of Social Security and the lack of pensions. So, think of tapping into your retirement account as a last resort, you should be working on a maximum 403b contribution (which is the same as the maximum 401k contritubion as well) in a perfect world.
Start with your emergency funds or other savings. If you’re faced with a short-term money crisis, this should be your first choice. That’s what it’s there for. If you’ve liquidated that, or it isn’t even an option, consider other ways to come up with the money. Sell some of your assets, try to refinance a loan if you’re stuck with a relatively high interest rate, or even reduce your monthly retirement or savings account contributions if that will help you bridge the money gap.
But at the end of the day, borrowing money from yourself isn’t the worst thing you can do, and if that’s your only option other than going into high-interest credit card debt, then it isn’t a terrible idea. Just remember to only borrow what you really need, don’t treat it as free money, and be prepared to repay the loan in the event you lose your job before it’s paid off.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.