Money Monday: Another Way to Fund Your Purchase

Golden nest egg concept as a retirement plan metaphor with a man standing at the bottom of a rock cliff thinking of a strategy to achieve his financial investment goal perched at the top of a dangerous the high mountain.
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In professional athletics you often hear of players who are in their final year or season of an expiring contract with a team in which discussions for a new contract has not materialized, making a statement that they are going to “bet on themselves.” By that, they mean that they will take the risk of playing without any agreement, or guarantee, and with the risk of injury during the season, instead of holding out for a new contract.

Last time we discussed potential sources of funding when you need to purchase assets and some of the consequences associated with those sources. However, we did not mention a very important option which is the subject of today’s Money Monday: borrowing from your retirement, to fund your asset purchases or investments.

Borrowing from your retirement is not the place you first consider when thinking about needing money, let’s say to purchase your next vehicle or another asset. But conceptually how it works and the benefits seem to make sense and could yield you favorable results.

For example borrowing from your retirement is comparable to borrowing from your credit union or bank with regards to terms and conditions, with a few exceptions. One thing that is curious to me is that despite the similarities in concept of borrowing, psychologically, people are more comfortable borrowing from an outside institution than borrowing from or betting on themselves.

The Upside

The interest rate in borrowing from your 401 (k) retirement plan may be cheaper than that from your bank, credit union or other funding sources. Therefore, why would an individual with less than an ideal credit, pay interest rates ranging from 11% to 14% for a new vehicle and 18% to 21% for a used vehicle? And, that’s not to mention the real issue of what will be paid in Annual Percentage Rate (APR).

Another positive of exercising this option to fund your asset is that the interest paid on the retirement loan is accruing to your benefit, to your retirement account. If your retirement account is earning 6% or more from the loan, would you rather not pay yourself, than have to pay someone else?

The other related assumption is that the market will continue to provide a better return on your retirement account than what you will be repaying in interest. Furthermore, you benefit from not having to pay origination and other loan fees associated with borrowing from banks and other institutions. These transactions are quite flexible and could be much easier to execute in a matter of days rather than weeks.

There is also the comfort knowing that early repayment of the loan will not result in any penalty. Perhaps the best news on this point is that missed or late repayments will not impact your credit score and most traditional loans would.

The Downside

Just as athletes may take risks associated with “ betting on yourself,” it’s no different when it comes to borrowing from your retirement account to fund your assets. You will have to find out from your 401(k) plan sponsor whether or not you are eligible to borrow from your account.

First you should know some of the rules from our favorite government agency and most quoted letters of the alphabet- IRS ( Internal Revenue Service). Plan sponsors are not required to include loan provisions in their plan, which is why you need to consult with them for information regarding eligibility. Also, IRAs (Individual Retirement Account), and plans like those, are not allowed to provide loans. Loans from your IRA or IRA-based plans would be considered prohibited transactions according to the IRS.

Assuming you are eligible, IRS rules, when translated into English, state that the most you can borrow is $50,000, or half of the amount in your vested account, whichever number is lower. An example would be if your vested retirement account balance is $90,000, you will only be allowed to withdraw $45,000, which is less than the maximum amount of $50,000. These amounts were increased during Covid-19.

But there’s more! According to the rules, except for borrowing money to purchase a home, the law requires the loan to be repaid within five years. It also requires payments to be made at least quarterly.

The other major concern is that default on loans or loans which do not meet the legal requirement are “deemed distributions,” meaning they are considered no different than you withdrawing money early from your retirement account and will result in you having to pay the early distribution penalty of 10% along with your income tax bracket payment rate. It might be instructive to know how IRC ( Internal Revenue Code) Section 72 (p) works before taking the leap!

If you’ve had enough IRS lingo, here are a few other potential down sides. Some plans prohibit accepting contributions while your loan remains outstanding. This is big deal because it means that you will not only be unable to make contributions, but you will not be receiving the match from your employer during this period.

Takeaways

While borrowing from your retirement is a great idea and option, you really need to think through all the factors. Is this going to be a short term or long term borrowed amount? How far are you from retirement? Some retirement plans require your spouse to sign a written consent before the participants can withdraw amounts over $5,000. Can your marriage survive these financial decisions?

WHAT’S UP!

Today’s What’s Up is about the great wealth transfer. According to investment advisor Edward Jones Company, only 27% of Americans have discussed passing down their assets to their families, while 48% plan to leave an inheritance. These numbers are even lower when it comes to communication on passing on assets in the African American community. This is true in part because some believe they have nothing to pass onto the next generation.

A Cerulli Association research study found that by 2045 the baby boomers and silent generation are expected to leave an estimated 72.6 trillion to their heirs. The subject is not taboo. Start having those conversation now with your family. And that’s what’s up!

 

Ruthven R. Phillip, Esq., is a tax attorney, Stewardship and Philanthropy Ministry Assistant, and CEO of Give2Getrich, LLC. Give2Get Rich, LLC 2024. All Rights Reserved. Any distribution or reproduction of part or all of the contents in any form is

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