There are substantial financial penalties enforced by the IRS for early 401k withdrawal — that is, cashing in your 401k before the age of 59.5. So if you get into a serious financial pinch, you’ll likely want to consider taking out a 401k loan before opting for a 401k withdrawal and signing yourself up to pay those penalties.
Why Most Advisors Recommend a 401k Loan Over a Withdrawal
401k loans — commonly referred to as “borrowing against your 401k” — are often preferred over making an early (penalized) withdrawal from your 401k, because the downsides tend not to be much worse than the penalties for early withdrawal. This doesn’t mean you can borrow the entirety of your 401k, however. If you decide to take out a 401k loan, you’re only going to be able to borrow the lesser of $50,000 or half of your retirement plan balance.
If you’re thinking of taking a 401k loan, you probably have a good reason. A medical emergency not covered by insurance. A serious, unplanned financial setback. A job loss in your household. Taking a 401k loan is a big decision, but there are some up-sides to borrowing against your 401k.
First of all, unlike other loans, there’s typically no credit check involved in qualifying for a 401k loan. That’s because you are, in effect, borrowing from yourself. Your 401k is made up of money you’ve saved in your company’s 401k plan. (If you’re lucky your company has matched your contribution.) But this is your money for your retirement.
That said, taking a 401k loan is not the same as taking money out of your savings account. Borrowing your retirement money has it’s own potentially dire implications, but it also means a credit check doesn’t really come into play. By the same token, you likely won’t need to pay any substantial application fees like you might have when buying a home.
The other up-side worth mentioning isn’t the fact that you’ll be charged interest on the 401k loan, but that all the money that you pay back will go straight into your 401k. These up-sides don’t offset the risks of a 401k loan in most cases, however. Most financial advisors agree a 401k loan should only be considered after other options are exhausted.
Explore Other Options Before Considering a 401k Loan
Even though a 401k loan may be a better option than an early 401k withdrawal, it should not be the first place you turn. In addition to the more tangible risks we’ll talk about below, borrowing against your 401k puts you at risk of not having enough money to retire when it’s time.
Not planning to retire? Thinking you’ll just keep working? Unemployment rates are increasing more rapidly for those over 50 than for any other age group right now. For most, working much past 60 or 65 presents a serious challenge in today’s employment environment.
Here are some alternatives to 401k loans that are worth considering first:
- Borrow from a friend or family member
- Take out a traditional loan if you qualify
- Downgrade your vehicles or even apply for a home equity line of credit
- Liquidate any other investment accounts you have that are not specifically tabbed for retirement
The Risks of 401k Loans
401k loans are serious business. The biggest risk to those borrowing against their 401ks is that the potential loss of future income as a retiree. By reducing the size of your 401k dramatically, you’re effectively stunting the growth of your 401k in the long-term. Your retirement is the single most important investment of your life. It’s nothing to place bets with.
For example, most financial advisors now recommend prioritizing your savings retirement even over paying for the college education of your children.
Failure to pay back your 401k loans on time can result in the same fees as an early 401k withdrawal, meaning you’ll be charged state and federal income taxes on it in addition to paying the 10% penalty that comes with an early withdrawal.
In most cases you’ll have just 5 years to repay the loan — unless you’re using it to buy your first home. What’s worse, if you lose your job for any reason, the outstanding balance of your 401k loan will be due in 60 days. If you can’t pay it all within that window, the loan will be considered a withdrawal.
There’s another negative tax result that is unavoidable when you take a 401k loan, too. The money you’ll have to use to pay back your 401k loan will have to come from your take-home pay. So if your payments to your 401k loan are $150, your paycheck will be $150 less each pay period. Mathematically, the interest you pay back on the loan as part of each payment is taxed twice. First, when you pay it with taxed take-home pay, and again, when you cash in your 401k after you retire because 401ks are tax-deferred investments.
401k Loan Final Thoughts
If you’re considering withdrawing early or taking out a 401k loan, the first thing you should do is get some personalized financial advice. The generalizations in this blog post are meant to get you thinking, not to help you make up your mind. Talk to a professional one-on-one to decide what your best option is personally.
Have you ever taken out a 401k loan? What were the risks? What do you wish you knew before? Would you ever do this if you haven’t? Let’s get the conversation going below.
The post 410k Loan Facts: When to Borrow Against Your 401k appeared first on DailyPerk.
