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Should You Borrow Against 403(b), 401(k) or Other Retirement Plans?

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Borrow against 403(b) plans or any other type of retirement plan at your own perilDon’t overlook your retirement plan as a source of short-term liquidity. You can borrow against 403(b), 457(b), 401(k) or a Roth IRA if the plan sponsor allows it, but only the solo 401(k) lets you do so without having to pay penalties or interest.

Among the plans that offer loans, the IRS limits borrowing against them to “(1) the greater of $10,t000 or 50% of your vested account balance, or (2) $50,000, whichever is less.”

You can take out more than one loan at a time but the total amount of outstanding borrowed funds must not exceed the maximum stipulated by the IRS.

Borrow Against 403(b) or Other Retirement Plans

Interestingly, the interest charged on loans against 403(b), 457(b), 401(k) and Roth IRA plans are set by the retirement plan sponsor. But if you decide to just cash out altogether by withdrawing funds early, rather than borrowing, you pay a 10% penalty if you’re below age 59.5.

That 10% does not include taxes, and unfortunately these withdrawals are taxed as income, according to the bracket you fall into.

A retirement plan withdrawal has the potential to move you into a higher tax bracket for the year — and the boundaries between each of the brackets has moved under the newly enacted Tax and Jobs Act, as you can see in the table below.

Should you borrow against 403(b) plans -- or 401(k), 403(b), or 457(b), for that matter?

Go Solo If You Can

As alluded to earlier, borrowing from a solo 401(k) is cheaper than other types of loans in the most literal sense that there’s no interest nor penalty.

However, the longer you take to repay the loan, the more of an opportunity cost you incur because your money is not getting the chance to accrue value through being invested in the market.

If your credit score is less than perfect, you might find borrowing from your retirement plan to be a great deal cheaper than any other type of loan.

What If You Have No Other Choice?

Although lenders have eased up their guidelines for approving loans in recent years, it’s entirely possible you still might not qualify for any loan at all if your credit score is below 600.

This  might leave you no other choice but to borrowing against 403(b) or any other types of retirement plan you might have.

But if you have no other way to borrow money, rethink whether taking on any additional debt will help your situation — it may not help.

You may gain some clarity about this decision by obtaining the total cost of borrowing from your retirement plan — this calculator helps you arrive at that.

Readers, have you thought about whether to borrow against a 403(b) or other type of retirement plan? 

What You Should Know About Roth IRA Conversions

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roth ira conversions
There is a lot being written about converting to a Roth IRA these days. With so much money being tied up in IRAs, it is becoming a very important question.

When thinking about converting from a traditional IRA to a Roth IRA, not only do you have to figure out how much to convert, but you also need to think about when and over how long of a time period.

When using a traditional IRA, you contribute your dollars pre-tax, and you will pay taxes only when you withdraw later in retirement. Roth IRAs are a bit different. You cannot deduct the contributions from your taxes, but when you withdraw later on, nothing is taxed.

In general, the goal is to minimize your taxes. But it’s a bit more complex than that. It also depends on the timing of the tax savings.

The Roth IRA vehicle was only created 20 years ago. It is just now starting to become mainstream. Although most people should probably not convert to a Roth IRA, it is worth it for nearly everybody to at least find out if it makes sense for them. The tax savings could be enormous.

Moving Tax Brackets

If you think you will be in a higher tax bracket when you retire, or if you know you will have very lot tax years coming up, you should definitely look into whether or not a Roth conversion makes sense.

One reason many people cite for wanting to convert a traditional IRA to a Roth is the lure of early retirement. Let’s look at a case study. We have a person, John, who wants to retire when he’s 50. The problem here is that John cannot use his IRA money (without a 10% penalty) until he’s 59.5.

roth ira conversions
This is one case where a Roth conversion can be very helpful. Here is what John can do:

  1. Transfer all IRA money to a Roth IRA.
  2. Pay the taxes on the transfer (you will be your marginal income tax rate on this). If possible, pay the taxes out of taxable accounts and not out of the IRA itself.
  3. Wait at least five years and then begin to withdraw from the Roth IRA, tax-free and penalty-free.

This strategy will allow John to begin using his retirement money at age 55 rather than age 59.5 and he won’t pay the 10% penalty.

Now let’s look at running some actual numbers to see when a conversion makes sense.

Running The Numbers

Let’s look at another case study. John and Jane are 54 years old. They plan on retiring next year. They will be start receiving large pensions at age 62 and social security at age 67. Currently their federal tax rate is only 10%, but that will increase dramatically at age 62 when their pensions kick in. This is a perfect example of a couple who should probably do a Roth conversion.

roth ira conversions
With their current plan where they keep their traditional IRA as-is, they only have a 62% chance of never running out of money, according to the WealthTrace Monte Carlo simulator.

But what if they convert their entire $600,000 IRA to a Roth over a seven year period when their tax rate is low? I ran this scenario and it helps them quite a bit. The results are below:

Their probability of never running out of money jumps by 9%. Part of the reason is that their tax burden would decline by nearly 30%, as you see in the table above.

A Roth conversion is not for everybody, but for some it could be a life-saver in retirement.

Photo: CafeCredit.com