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.
Susan Johnston Taylor is an Austin, Texas-based freelance writer for TraditionalIRA.com and RothIRA.com. She has covered personal finance and small business for publications including The Boston Globe, Entrepreneur, Fast Company, and U.S. News online.