Should I Take A Loan From My 457(b) Deferred Compensation Plan?

Imagine you’re in a financial pinch and need access to some cash. You’ve been contributing to your 457(b) plan for years, and it’s built up a significant balance. Taking a loan from your retirement savings seems like an attractive option. After all, it’s your money, and the idea of paying yourself back sounds like a win-win, right?

But here’s where things get tricky. You take the loan, but the realities of repaying it can quickly become overwhelming. If you miss a payment or aren’t careful with the repayment terms, you might find yourself in a worse situation than before. And, worse yet, if you’re not diligent about paying yourself back, you could inadvertently hurt your long-term retirement goals. 

Many people assume that 457(b) loans are straightforward, but there’s more to them than meets the eye. You need to understand the rules, how to handle repayments, and the potential consequences of not following through. Without a clear strategy, a loan can derail your retirement planning rather than help you achieve it.

The Real Issue

As a financial advisor specializing in 457(b) plans, I’ve seen firsthand how people struggle with the decision to take a loan from their retirement accounts. One of my clients, a municipal employee, found themselves facing unexpected medical bills and decided to take a loan from their 457(b) plan. They felt confident at first, believing they could easily repay the loan by the end of the year.

However, things didn’t go as planned. The client’s situation changed, and they missed a few weeks of work and fell short on their other bills. The interest they were paying on the loan was essentially “paying themselves back,” but they were missing out on potential investment gains in their 457(b). Over time, they started to feel the strain of this missed opportunity.

This scenario isn’t unique. I’ve seen many folks who took 457(b) loans only to regret their decisions later, realizing the importance of keeping their retirement funds intact. They wished they had approached the loan process with more caution and a clearer repayment strategy in place.

What is a 457(b) Loan?

A 457(b) loan allows you to borrow money from your 457(b) plan balance for various personal needs, such as medical expenses, home repairs, or other emergencies. The loan must be repaid over a specified period, typically within five years, and interest is paid to your own 457(b) account. The key benefit here is that the loan interest you pay doesn’t go to a bank—it goes back into your 457(b) account, essentially “paying yourself back.

In most plans, there’s two types of loans:

• Principal residence loans: A specific type of 457(b) loan where participants borrow from their 457(b) plans for the purpose of purchasing or building their primary residence. This type of loan can be a bit more complex because it involves the use of retirement savings for a significant personal purchase, and there are some important factors to consider before moving forward. Generally, these loans range from 61 – 180 months. This is automatically deducted from your paycheck.
• General Purpose Loan: These loans can be taken for any purpose. They must be paid back within a specific period, generally 12 – 60 months. This is automatically deducted from your paycheck.

The Pros and Cons of a 457(b) Loan:

Pros:

• You’re borrowing from yourself
• The interest payments go back into your 457(b) account, helping to rebuild your retirement savings.
• It can be a relatively quick way to access cash without incurring high-interest rates from traditional lenders.

Cons:

• The loan balance must be repaid through payroll deductions, which can impact your cash flow.
• Taking a loan from your 457(b) reduces the amount of money you have invested, meaning you could miss out on investment growth.
• If you leave your job before repaying the loan, you may be required to repay the full balance in a short period, typically within 60 days.

Repayment of a 457(b) Loan

When you take a loan, you agree to a repayment schedule, usually with regular deductions from your paycheck. Interest is charged on the loan, and the interest payments are deposited back into your 457(b) account. The key thing to remember is that while you are paying yourself back, you’re also temporarily reducing the amount of money in your 457(b) account, which could potentially lead to lower returns from your investments.

What If I Leave Employment?

If you leave employment with an outstanding 457(b) loan, there is two options. You can fill out a loan offset form, this will distribute a 1099 for that year for the amount of the outstanding loan. You will need to fully close out the loan before taking any withdrawals. In addition, if within specified plan document time (generally 30-90 days) you may pay off the loan balance in full. Every plan may be different, so ensure to check the plan provisions.

What’s Next?

Now that you understand the basics of 457(b) loans, here’s a step-by-step guide to help you manage the loan and ensure that it doesn’t derail your long-term retirement goals.

Evaluate the Need for a Loan

Before taking a loan, it’s important to evaluate whether this is truly the best option for your situation. A 457(b) loan should only be taken when absolutely necessary. Ask yourself:

• Are there other ways to cover this expense, such as using an emergency fund or a personal loan with a lower interest rate?
• What is the long-term impact of borrowing from my retirement savings?
• Can I afford the repayments on my current income without compromising other financial goals?

Understand the Loan Terms

Before signing any paperwork, make sure you fully understand the terms of the loan. This includes:

• The interest rate: Ensure you’re aware of the rate and how it compares to other types of loans.
• The repayment period: Most 457(b) loans must be repaid within five years. If you plan to take a loan for a home purchase or another long-term need, make sure you’re comfortable with the repayment schedule.
• The impact on your retirement savings: Remember that the loan reduces the amount you have invested in your 457(b) account, and you could miss out on potential returns.

Set a Realistic Repayment Plan

One of the most crucial aspects of a 457(b) loan is the repayment plan. This plan should fit seamlessly into your budget, ensuring that you can make the necessary payments without sacrificing your financial health. Here’s how to create a repayment plan:

• Calculate your monthly payments: Use an online loan calculator or consult with your plan administrator to determine how much you’ll need to pay each month.
• Adjust your budget: Reevaluate your budget to ensure you can comfortably afford the loan payments. If necessary, adjust your discretionary spending to make room for the loan.
• Avoid missing payments: Set up automatic payments or reminders to ensure that you never miss a payment. Missing payments could trigger penalties and taxes.

Consider the Opportunity Cost

When you take a loan from your 457(b) plan, you’re pulling money out of your retirement investments. This means that money is no longer working for you and earning returns. It’s important to weigh this opportunity cost:

• If you take out a loan, you may not be able to achieve the same level of growth as if the money were left in the account.
• Consider whether the immediate financial need outweighs the long-term loss of compounding growth in your retirement plan.

Be Prepared for Employment Changes

If you leave your job for any reason, including retirement or a job change, the full balance of the loan may become due. Each plan may have different loan rules. It’s important to check with your plan administrator. 

To avoid this scenario:

• If you’re considering leaving your job, pay off the loan before making the move.
• If you’re not able to repay the loan in full, explore other options, such as a loan offset form.

Re-evaluate Your Loan After Major Life Events

Life changes, such as getting a raise, facing a new financial challenge, or changing your retirement plans, can impact your ability to repay a 457(b) loan. Periodically revisit the loan terms and adjust your repayment plan as needed to ensure that your loan doesn’t negatively affect your overall financial situation.

A Final Overview

457(b) loans can offer flexibility in times of financial need, but they also come with significant risks that can affect your retirement plans. By evaluating the necessity of the loan, understanding the terms, setting a realistic repayment plan, and accounting for the opportunity cost of withdrawing funds, you can make an informed decision that minimizes the impact on your retirement savings.

It’s important to recognize that while the idea of “paying yourself back” may seem appealing, the true cost of borrowing from your retirement account can be substantial. Always weigh the pros and cons carefully, and ensure you have a clear plan for repayment.

If you’re unsure whether a 457(b) loan is the right choice for you, consult with a financial advisor who can help guide you through the process and ensure that you’re making the best decision for your long-term financial security.