Retirement accounts include qualified employer plans, nonqualified employer plans and individual retirement accounts. Qualified employer plans include 401(k)s, 403(b)s and 457s. These plans allow you to deduct your contributions. Nonqualified employer plans, such as deferred compensation plans and executive bonus plans, don’t provide tax deductions. As long as the plan permits it, you can borrow from an employer plan or pledge it as collateral, subject to certain restrictions involving “disqualified persons.”
Pledging an IRA
A traditional IRA offers tax-deductible contributions and tax-deferred growth of your investments. You must pay taxes on withdrawals and might have to pay a 10 percent penalty on withdrawals before age 59 1/2. A Roth IRA provides no tax deductions but does offer tax-free growth and withdrawals after owning the account for five years and reaching age 59 1//2. However, you can withdraw Roth contributions tax- and penalty-free at any time. The Internal Revenue Service doesn't permit you to borrow from an IRA or to use it as collateral. If you do so, the IRS will no longer consider the account an IRA and will tax it as if you withdrew all the money on January 1. This also might result in the early withdrawal penalty if you're under the age of 59 1/2. These rules also apply to SEP IRAs and SIMPLE IRAs.
Pledging a Qualified Plan
The rules for pledging a qualified plan -- that is, using it as collateral -- are set down in IRS Regulation 1.401(a)-13(d). Under this regulation, you can pledge the “accrued nonforfeitable benefit” of your account if your qualified retirement plan allows loans and the loan or pledge is not made to a disqualified person. The IRS's definition of disqualified persons includes those controlling or providing services to the plan, the employer, an employee organization with members covered by the plan, majority stockholders of the employer and family members of disqualified persons. Certain exceptions allow loans and pledges to disqualified persons who are plan participants or beneficiaries.
Protection From Collection
Even if it’s legal to pledge your qualified employer plan as collateral, lenders might be reluctant to accept this collateral. The Employee Retirement Income Security Act of 1974, or ERISA, protects qualified employer plans from collection by creditors. This means that even if you pledge your 401(k) to collateralize a loan, the lender can’t seize your plan if you default on your loan. However, this protection doesn't necessarily apply to cases involving family members.
Qualified Domestic Relations Order
If you pledge your qualified plan to certain family members, a state court can issue a qualified domestic relations order, or QDRO, that allows the family member to seize the collateral. The family member can be a spouse, ex-spouse, child or other dependent. QDROs normally cover disputes regarding child support, alimony or marital property rights. You don’t have to borrow from or pledge your qualified employer plan for the plan to be seized via a QDRO. ERISA protection doesn't extend to nonqualified employer plans.
About the Author
Based in Chicago, Eric Bank has been writing business-related articles since 1985, and science articles since 2010. His articles have appeared in "PC Magazine" and on numerous websites. He holds a B.S. in biology and an M.B.A. from New York University. He also holds an M.S. in finance from DePaul University.
- Thomas Northcut/Digital Vision/Getty Images
What You Need to Know About 403(b) Loans
by Susan Johnston Taylor
If you find yourself in a tight spot financially—a surprise medical procedure or fewer hours resulting in less income—then in some cases, you might be able to borrow money from your 403(b) retirement account rather than taking an early distribution or using higher-interest debt.
Stefanie Carter, who’s a nurse at a nonprofit hospital, took out a 403(b) loan in November 2015 when she needed to catch up on rent. “I thought it made more sense to borrow against myself and pay myself back versus borrowing from someone else,” she explains. Carter opted for a two-year repayment term, so she’ll make her final payment later this year.
However, Joshua Gottfried, CFP, of Gottfried & Somberg Wealth Management in Glastonberry, Connecticut, cautions that retirement accounts shouldn’t be treated like bank accounts and encourages clients to borrow with caution. “When you borrow from a retirement account, it doesn’t feel as bad borrowing from other things, which makes it easier to borrow that money and makes the rationalization of spending that money easier,” he says.
Here’s a look at what you need to know before borrowing from your 403(b)
- Not all employers allow 403(b) loans. Your 403(b) plan’s rules will dictate if loans are even allowed. “If they all fall under ERISA, in that situation they have one plan for the whole company, and the vast majority of those plans allow loans,” Gottfried says. “Non-ERISA 403(b)s including public schools, some higher ed and some hospitals may not. In that world, even within a district, you can have multiple plans with multiple rules.” In plans where loans are permitted, you can typically only borrow up to 50 of your vested account balance, up to a maximum of $50,000. Some plans also charge small loan origination fees.
- Repayment is typically five years or less. Unlike mortgages, where repayment may be stretched out over 10, 15 or 30 years, 403(b) loans tend to have a shorter repayment term of up to five years. Carter didn’t want the loan hanging over her for long, so she chose a two-year repayment term.
- Missed payments can trigger taxes and penalties. Depending on your plan, your repayments may come from a bank account or from automatic withdrawals from your paycheck. Choosing a shorter repayment term to extinguish the loan sooner may be tempting, but make sure that your monthly payment is still realistic, even if other unexpected costs pop up. Missing a payment or defaulting on a retirement loan can convert what you’d intended as a loan into an early retirement distribution with taxes and penalties.
- Borrowing from your 403(b) means less money in retirement. While borrowing from your retirement account and repaying yourself may sound harmless, remember you’ll miss out on some tax-free growth during the repayment period. Also, while you’re paying it back, you may not be able to make additional contributions to your retirement account, which can hinder retirement savings further. Carter says her plan does not allow her to contribute to her 403(b) for six months after she took out a loan, but she still felt it was her best option.
- If the loan is for a divorce, you have other options. Gottfriend sometimes see clients who consider a 403(b) loan because they need more liquidity to transfer assets during a divorce and haven’t consulted a divorce attorney about alternatives. “They may not be looking at things like a QDRO (qualified domestic relations order) and other ways of dividing assets in a tax efficient manner,” he says. A QDRO awards a portion of a spouse’s retirement account to the other spouse without a retirement loan or early distribution.
- Policies vary on when happens if you leave a job with an outstanding loan. If you leave or get laid off from a job while you’re still paying back a 401(k) loan, the entire outstanding balance becomes due within 60 days. While 403(b) are similar to 401(k) loans in many ways, that’s not always the case with 403(b) loans. Gottfried says policies on this issue vary by plan, so if there’s any possibility of a job change, be sure to ask how this would impact your 403(b) loan before you borrow money.
Just because you can doesn't mean you should
Just because your 403(b) plan allows you to borrow money for a financial hardship doesn’t mean that you should. Gottfriend says the best use for a 403(b) loan is one-time unexpected expenses such as emergency surgery where you’ll be able to get back on track financial afterwards. But if the issue is caused by general lifestyle spending, perhaps you need to lower your 403(b) contributions and free up excess cash in other ways. Borrowing money to deal with lifestyle spending doesn’t address the root cause, so you may need another loan in the future.
Whatever the reason for a 403(b) loan, be sure you’ve explored all your options and fully understand what the loan means for your future retirement savings.
back to topview all healthcare stories »