Is It Ever a Good Idea to Take a Loan From Your 401(k)?
Filed under: Supplemental Retirement Income
Your employer 401(k) plan is likely one of your most important retirement assets. A 401(k) offers the combined power automatic pre-tax contributions, matching employer contributions, and tax-deferred growth.
While a 401(k) is a retirement savings vehicle, people are often tempted to tap into their plan for financial needs that aren’t retirement-related. Life is unpredictable, and when you face a significant financial threat, like medical bills, unemployment, or home repairs, a 401(k) distribution might seem like the only feasible option.
Most plans won’t allow you to take a 401(k) withdrawal while you’re still a participant. However, you may be able to take a loan. Just because you can take one, though, doesn’t mean you should. If you’re thinking about taking a loan from your plan, here are a few things you may want to consider:
Why a 401(k) Loan Might Make Sense
One appealing aspect of a 401(k) loan is that there’s usually no credit check, approval process, or underwriting required. As long as you have enough funds in plan to cover the loan, the process is usually as simple as filling out a form. This may make a 401(k) loan an appealing option if you have challenged credit and wouldn’t qualify for other types of loans.
Very often, the interest rate on a 401(k) loan is lower than the rates you’ll find on credit cards and other traditional types of debt. This also might make it an appealing option if you have a credit situation that would make it difficult to get approved for other kinds of loans with competitive rates.
Another potential appealing factor is that the distribution is not taxable. Withdrawals from 401(k) plans are nearly always taxable, but loans aren’t because they have to be repaid. Additionally, with a 401(k) loan you avoid the early distribution penalty that is typically charged for withdrawals that occur before age 59 ½.
Why a 401(k) Loan May Not Make Sense
One of the biggest advantages of having a 401(k) is that it allows you to grow your savings in a tax-deferred manner. That means the gains you see from your investments in the plan are not subject to taxes as long as the funds remain in your account. Tax-deferral may help your funds compound at a faster rate. However, to take full advantage of tax-deferred growth, you need to maximize the amount of funds you have in the plan.
If you take a portion of your 401(k) out through a loan, those funds are no longer in the plan to grow on a tax-deferred basis. That could slow your growth and limit your ability to hit your retirement savings goal.
Taking a loan from your 401(k) also creates a complicated tax situation. Normally, when you put money into your 401(k) it’s pre-tax, which means those contributions aren’t included in your taxable income.
Repayments on your loan, however, are made with after-tax dollars. That means you’ll pay taxes on your repayment dollars before those funds go into the plan. Additionally, you’ll also pay taxes on those funds when you withdraw them in retirement.
Another potential risk of taking a 401(k) loan is that it could become a taxable distribution. Failing to repay your loan or switching jobs before you repay it puts the loan into default status. Once this happens, it automatically becomes a withdrawal. This means the distribution becomes taxable. On top of that, you might also face the 10 percent early distribution penalty if you were under age 59½ when you took the loan.
Are you considering using a 401(k) loan to fund a major financial goal? There may be better options available. Let’s talk about it. Contact us at Ambrose Financial and Insurance Services. We can help you analyze your needs and develop a strategy. Let’s connect today.
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16441 – 2017/2/15
