Retirement Account Loan Strategies You May NOT Have Thought About

Taking a retirement plan loan may be considered taboo in some cultures, primarily because it can be detrimental to your retirement preparedness. That said, not all retirement plan loans are bad.

For instance, if you are carrying a balance on a high-interest credit card, taking a retirement plan loan may be a sensible way to pay off the debt faster while paying the interest to yourself. Or maybe you plan to use the money to help fund a child’s college tuition, or to pay for an unexpected medical bill. All of these could be seen as valid reasons for borrowing from your retirement account, but that doesn’t negate the fact that you may still be jeopardizing your future retirement goals.

If you are considering a loan, here are a few tips and strategies to make it less costly and more beneficial for you now, and in the future:

Before you submit your loan request

There are at least two things you should do before submitting your loan request.

  1. Model the loan to make sure it doesn’t put too much of a strain on your current cash flow. Most retirement plan providers offer loan modeling so that you can estimate how much will come out of each paycheck in loan payments. Compare this to your budget and adjust spending as needed.
  2. Run a retirement projection to see if you are on track to reach your retirement goals. If not, determine what changes you can make now to get on track.

Take advantage of tax breaks

Depending on the purpose of the loan, you may be eligible for tax breaks as well. Here’s how:

For medical expenses

Are you using the loan to help pay for medical expenses incurred while eligible for a health savings account (HSA)? If so, then consider depositing the proceeds of your loan—up to the annual contribution limit—into your HSA and then withdrawing the funds to pay for qualified medical expenses from there. That way you get the tax deduction on your contribution, and tax-free money to pay for your medical expense.

For college-related expenses

Are you using the loan to pay for tuition, fees, or other qualified educational expenses? If so, then you may be eligible to claim one of two educational tax credits.

If you’re not eligible for tax credits—either because your income is too high or you are paying for an unqualified expense like room & board—your state may offer income-tax deductions (or other benefits) for contributing to their 529 plan. In this case, consider depositing the loan into your state’s 529 plan, and then withdrawing the funds to pay for college-related expenses — there’s no requirement that the funds have to stay in the account for a certain amount of time. That way you get the state income tax deduction, or other benefits, associated with the plan.

Once the loan is paid off

By now you’ve probably adjusted your lifestyle to a lower paycheck. Once the loan is paid off, rather than increasing your current spending, consider one or more of the following strategies to help avoid future loans:

Stop using a credit card

Using a retirement plan loan may be a good way to pay off high-interest debt, but it would be even better to avoid high-interest debt in the first place. Sometimes it can’t be avoided, but when it can, it should.

Create/rebuild the emergency fund

Sometimes we need to take a loan because of unexpected events. Being prepared for the unexpected is part of a healthy financial plan. Now that you have a little extra in each paycheck, start setting that amount aside each month until you build up 3 to 6 months of expenses.

Contribute to a health savings account

As noted earlier, contributions to a health savings account (HSA) are deducted from income tax, and distributions are tax free when used to pay for qualified medical expenses. Best of all, unused funds remain in the account, and most plans allow you to invest the funds once they reach a certain threshold. For this reason, you may want to treat your HSA like it’s a supplemental retirement account.

Contribute more to your retirement plan

At a minimum, you should contribute up to your company match (if available), but if you can afford to save more you should. Not only will this offset any negative effect the loan may have had, but it will likely help you reach your retirement goals faster.

Start or add to a college savings account

If you or someone you love plans to attend college in the future, consider funding a college savings account. It may not pay for everything, but it should reduce the amount needed in student loans.

As a financial planner, I would prefer you save enough to avoid having to borrow in the first place, but if a retirement plan loan seems to be your best option, then learn how to get the most out of it. Maybe then it won’t be so taboo.

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