Deciding what’s better to take a loan or distribution from retirement income is no easy task. An essential piece of advice always to remember is your retirement income should be saved and used for, you guessed it, retirement!
However, as people get older, situations arise, and it can feel like an easy decision to dip into the retirement funds. Here are just a few of the things people purchase with their retirement funds: pay off debt, purchase a vehicle or boat, down payment on a home or other large purchase, and help children go to college or purchase their home. Depending on how long you need the money and what is being used to purchase will greatly affect whether you should take out a loan or distribution from your retirement income. In most cases, it is best to save your retirement income for your retirement, if possible.
Some retirement accounts will allow you to take out a loan against your retirement income. This will allow you to get a lump sum, which you can pay back into your retirement account by making payments. Usually, the interest rate is low, around 6% currently depending on the retirement fund provider and prime rate. Some companies only allow you to take out a loan, if you are still employed with them. So before deciding whether it is best for you to take a distribution or a loan, it is important to first check and see if taking out a loan from your retirement income is an option.
Once you take out a loan against your retirement income, that amount of money stops earning. In other words, until you pay back the loan with interest, it stops working for you. This fact alone makes taking out a loan a bad idea for most people. In addition to the interest, it can cost you hundreds and even thousands in future earnings.
Also, if you currently have a loan taken out against your retirement account and need another loan, you will need to refinance the whole loan. You cannot just take out a second loan. This can result in a higher interest rate for the entire loan.
At current interest rates, taking a loan from your retirement income is not as attractive. For example, if you want to use the funds to purchase a new car, you may be able to qualify for an auto loan that has a lower interest rate than the loan from your retirement account. This allows you to leave your retirement income alone to continue to work for you. However, there can be circumstances were a loan makes sense.
Example. Bruce and Barbara, who are retired, want to help their son purchase his $200,000 dream home. He just needed the loan for nine months until he remodeled the house and could qualify to take out a mortgage, which he would use to pay them back.
I leave the decision on whether to loan your son $200,000 to you. That’s a much larger conversation! Given the circumstances, it would be best for Bruce and Barbara to take out a loan against their retirement, since it is both such a large amount and will be paid quickly. However, depending on their financial circumstances, there may be better options available.
If they take out a distribution from their retirement account, they will not be able to put most of the money back into their retirement account, and they may have to pay income taxes. In fact, a distribution from most retirement accounts will require both state and federal income taxes to be paid. For additional information on how retirement income is taxed, read the article here. If Bruce and Barbara typically have $50,000 in taxable income, taking a distribution in this amount could push them into a much higher tax bracket. Between not being able to place most of the money back into their retirement account, loss of future earnings, and paying taxes, the difference between that and the loan interest could be tens of thousands of dollars.
A distribution is when you take money out of your retirement account. Many retirees save their retirement income, so they can take monthly distributions to supplement their other retirement income, usually from Social Security, pensions, or other sources. Other retirees take out large distributions to pay off their homes, cars, and other debts.
It’s important to remember most distributions from retirement accounts are treated like taxable income, both by the IRS and state. This means the money is taxed just like income from your job reported on a W-2. In most situations, although there are a few exceptions, if you are not 59 ½ years old, you will be penalized with an additional 10% owed on the distributions for early withdraw.
If you are considering taking out a large distribution to pay off debt, it may feel right, but it may not be the best decision. Your retirement income is protected in bankruptcy proceedings. Also, you must remember that you will owe federal and state taxes as well.
Deciding whether to take out a loan or a distribution from your retirement income is a big decision. It should not be one made hastily. Depending on your individual circumstances, taking out a loan versus a distribution or vice versa could save you thousands.
If you are considering either, schedule an appointment with the tax professionals at Gudorf Tax Group to make sure you have weighed all of your options and the effect this will have on your financial health. Don’t get caught with an unexpected tax bill or realize after the fact you could have saved thousands.