The pros and cons of taking out a 401 (K) loan

If you ever need cash in a pinch to cover unforeseen expenses, you may want to consider borrowing on your 401 (k) as an option – if it is not possible to secure financing elsewhere.

A 401 (k) is an employer-sponsored retirement savings plan that allows you to set aside money before tax (or after tax if you have a Roth 401 (k)) from your paycheck to help fund your years after you quit working. And while personal finance professionals don’t recommend looting your retirement plan for money if you can avoid it, one of the primary ways to leverage your 401 (k) plan is to get a 401 (k) loan. (k).

What is a 401 (k) loan?

A 401 (k) loan allows you to borrow money that you have saved in your retirement account for the purpose of paying yourself back. Even if you lend yourself money, it’s still treated like a normal loan by charging interest that you have to pay for.

When you take out a loan from your 401 (k) plan, you get terms just like any other type of loan: there is a repayment plan based on how much you borrow and the interest rate you lock in. According to the IRS rules, you have five years to repay the loan, unless the funds are used to purchase your primary residence, in which case you have more time to repay.

However, a 401 (k) loan has some major drawbacks. Although you do reimburse yourself, a major downside is that you are still withdrawing money from your retirement account which accumulates tax-free. And the less money there is in your plan, the less money accumulates over time. Even when you pay back the money, it has less time to fully develop.

Also, if you have a traditional 401 (k) plan, you will repay the pre-tax funds to the account along with your after-tax income, so it takes even more – in terms of working hours – to pay off the loan.

Risks associated with taking out a 401 (k) loan

Before you decide to borrow money from your 401 (k), keep in mind that this has its drawbacks.

You can’t get one. Whether or not you can get a 401 (k) loan depends on your employer and the plan they have in place. A 2020 study by retirement data firm BrightScope and the Investment Company Institute found that 78% of plans offered plan members the option of borrowing based on 2017 data, so you may need to look for funds elsewhere.

You have limits. You may not be able to access as much money as you need. the maximum loan amount is $ 50,000 or 50 percent of your acquired account balance, whichever is less.

Old 401 (k) do not count. If you are considering tapping into a 401 (k) from a company you no longer work for, you’re out of luck. Unless you’ve transferred this money to your current 401 (k) plan, you won’t be able to use it.

You could pay taxes and penalties on it. If you don’t pay off your loan on time, the loan could turn into a payout, meaning you could end up paying bonus taxes and penalties on it.

You will have to pay it back faster if you quit your job. If you change jobs, resign, or are fired by your current employer, you will need to pay off your unpaid 401 (k) balance within five years. Under the new tax law, 401 (k) borrowers have until the due date of their federal income tax return to repay in such circumstances.

For example, if you had a 401 (k) loan balance and left your employer in January 2022, you will have until April 15, 2023 to repay the loan to avoid default and any tax penalties for early withdrawal, according to The Retirement. Company of the Plan. The old rule was for a refund within 60 days.

Benefits of borrowing from a 401 (k)

Borrowing on your 401 (k) is not ideal, but it does have some advantages, especially over withdrawing early.

A loan allows you to avoid paying the taxes and penalties associated with an early withdrawal. Plus, the interest you pay on the loan will go back to your retirement account, albeit on an after-tax basis.

401 (k) loans will also not require a credit check or be listed as debt on your credit report. If you are forced to default on the loan, you won’t have to worry about it hurting your credit score because the default will not be reported to the credit bureaus.

Early withdrawals less attractive than the loan

An alternative to a 401 (k) loan is a distribution of difficulties in the context of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age (59 ½), you will generally be subject to income tax on all earnings and may face a 10% penalty, depending on the nature of the hardship.

You can also claim an allocation of difficulties with an early withdrawal.

The IRS defines a hardship breakdown as “an immediate and significant financial need of the employee,” adding that “the amount must be necessary to meet the financial need.” This type of early withdrawal does not require repayment and does not incur any penalty.

An allocation of hardship through early withdrawal covers a few different circumstances, including:

  • Certain medical expenses
  • Some fees for the purchase of a principal residence
  • Tuition, education fees and expenses
  • Costs to avoid being deported or seized
  • Funeral or burial expenses
  • Emergency home repairs for uninsured bodily injury

The difficulties may be relative and yours may not qualify you for an early withdrawal.

This type of withdrawal does not require a refund. But it’s a good idea to avoid an early withdrawal, if possible, because of the serious negative effects on your retirement funds. Here are some ways to get around these hefty taxes and keep your retirement on track..

Other alternatives to the 401 (k) loan

Borrowing on your own can be an easy option, but it’s probably not your only option. Here are some other places to find money.

Use your savings. Your emergency money or other savings can be crucial right now – and why you have emergency savings in the first place. Always try to find the best rate on an online savings account so that you earn the highest amount out of your funds.

Take out a personal loan. Personal loan terms might be easier for you to repay without having to jeopardize your retirement funds. Depending on your lender, you can get your money back in a day or two. 401 (k) loans might not be so immediate.

Try a HELOC. A Home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow. You can withdraw what you need, when you need it, up to the limit for which you are approved. As revolving credit, it’s similar to a credit card – and the money is there when you need it.

Get a home equity loan. This type of loan can usually offer you a lower interest rate, but keep in mind that your home is being used as collateral. This is an installment loan, not a revolving credit such as a HELOC, so it’s good if you know exactly how much you need and what it will be used for. While easier to get, make sure you can repay that loan or risk your home defaulting.

At the end of the line

If withdrawing money from your retirement is your only option, then a 401 (k) loan may be right for you. However, try to find other funds first before using this option. Depending on what you need and when you need it, you may have other choices that better suit your situation. Not having emergency or retirement savings is Americans’ biggest financial regrets.

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