Sometimes, it may feel tempting to take a 401(k) loan, especially if you’re strapped for cash. However, doing so comes with costly consequences.
Are you looking for an easy source of cash? Are you worried about borrowing from your retirement account? Are you tired of struggling to find a financial solution?
If you need cash in a hurry, you may have heard about 401(k) loans and their perks. About 20% of 401(k) owners take temporary money out of these accounts. However, this loan can have severe financial ramifications.
Just because the 401(k) loan option is available doesn’t mean you should use it. A 401(k) loan is not your only option for sourcing cash. You’ve delayed gratification and built these savings for a specific goal, retirement. Please think twice before you marginalize your retirement for cash flow maintenance.
Today, we’ll lead you through how a 401(k) loan works and the possible dangers it poses. Stay tuned for some safer financing alternatives!
How Does A 401(k) Loan Work?
Like most loans, 401(k) loans come with a repayment plan and a locked-in interest rate.
Here are a few key features that make 401(k) loans different from other loan types.
If your plan allows, you can borrow up to 50% of the account’s value (with a $50,000 ceiling) over five years.
No Hard Credit Check
Taking a loan doesn’t require a hard credit check. If you default on the loan, you won’t have to worry about it damaging your credit score because the default won’t be reported to credit bureaus.
The interest rates are usually low (1-2%). They are much lower than most personal loans you could acquire, even with a good credit score.
You Pay the Interest to Yourself
The interest you pay on the loan will go back into your retirement account on a post-tax basis.
No Extra Fees
Since the money is a loan, not a distribution, you don’t owe taxes or the 10% early withdrawal penalty on the funds.
- Low-Interest Rates
- No hard credit check requirement
- No taxes owed
- No early withdrawal penalty
The Costly Consequences of Taking a Loan From Your 401(k)
Although it can be tempting to borrow some cash, your 401(k) is usually best left untouched.
Here are five reasons why most advisors counsel against this borrowing practice.
1. Re-Funding Your 401(k) Account is Costly
One of the best benefits of a 401(k) is that contributions are pre-tax.
Unfortunately, you can only make loan repayments with after-tax money. You completely lose the pre-tax advantage on the withdrawn amount by taking a loan.
If you are in the 24% tax bracket, 24 cents out of every $1 you earn goes towards income tax. You are losing out on one-quarter of your earnings compared to when you made the original contribution.
2. Your Contributions May Decline
Some companies limit or even halt your ability to contribute to your 401(k) until you pay off your loan. This lack of contributions can significantly decrease your retirement savings.
On average, retirement savings double every eight years while invested. However, without the ability to max out your 401(k) each year, you miss out on company matches, growth opportunities, and compound interest.
3. You Will Miss Out on Important Compound Interest
Time is the most crucial factor when it comes to compounding interest. The longer your money is in the retirement account, the more compounding works in your favor.
Utilizing a 401(k) loan reduces your ability to gain compound interest. If you take the entire five years to pay off your loan, your loan amount is not earning interest during that period. That’s five years’ worth of returns you are missing out on!
4. You Could Make a Bad Financial Situation Even Worse
If you don’t repay your loan on time, you may end up paying taxes and penalties on it.
When you can’t make your loan payments and have to default, the loan becomes a withdrawal.
The outstanding loan balance will be taxed at your income tax rate and subject to a 10% early withdrawal penalty if you are below the age of 59½.
5. A Loan From Your 401(k) Limits Your Ability to Change Jobs
Taking a loan from your 401(k) severely limits your ability to take on new and exciting career opportunities.
Most 401(k) loans have a five-year payback period. However, if you change or lose your job while you have the loan, your repayment window quickly closes.
When you leave your old employer, you have until the next federal income tax return due date to repay. Additionally, there are harsh consequences if you don’t meet the new deadline.
For example, suppose your repayment is late. In that case, the loan could count as a distribution and come with hefty early withdrawal fees and taxes.
Give Yourself a Cash Cushion for Safety and Security
While a loan from your 401(k) might initially sound tempting, we suggest only using this source as a last resort.
Here are a few other resources to try first:
Emergency Savings Account – Savings accounts are a great way to store cash for upcoming needs. Generally, it’s a better idea to use your emergency fund or savings before dipping into your retirement account. We suggest pre-saving monthly for large ticket items.
Home Equity Line of Credit – A home equity line of credit enables you to draw funds as you need them by borrowing against your home equity. A HELOC adds flexibility, but it’s not without its downfalls.
Know All of Your Financing Options to Retire with Security
The best way to combat a money disaster is by preparing for it ahead of time.
It can be confusing and stressful trying to navigate the world of interest rates, penalties, withdrawal fees, and loans.
Our experienced Registered Investment Advisors at Bienvenue Wealth are here to help! We specialize in giving Gen X professionals the tools to create the lifestyle they want.
Take the fear out of your finances by scheduling a meeting with one of our trusted advisors today!