If you’re like many working Americans, your 401(k) may be one of your largest assets. If you regularly contribute to your plan and even receive matching contributions from your employer, your 401(k) balance can accumulate quickly.
Your 401(k) plan is designed to serve as a retirement savings vehicle. To encourage long-term savings, 401(k) growth isn’t taxed as long as the funds stay in the account. That tax deferral can often help funds compound at a faster rate than they would in a taxable account. You pay taxes on your 401(k) funds when you take distributions, and if you take a withdrawal before age 59½, you could also face a 10 percent early withdrawal penalty.
Often, plan participants are tempted to take money from their account before they reach retirement age. They may have a financial emergency arise, and a 401(k) distribution may seem like the only possible solution. Others may want to use the funds to pay for a large goal, like a home renovation, wedding or vacation.
Most 401(k) plans don’t allow active participants to take withdrawals, but many allow participants to take loans. The distinction between a withdrawal and a loan is subtle but important. If you’re considering taking a loan from your 401(k) plan, you may want to analyze your needs and the consequences carefully. Below are some important facts to guide you through the process:
Why a 401(k) Loan May Make Sense
Generally, it’s wise to look for other funding sources besides a loan from your 401(k). However, there are a few reasons why a 401(k) loan may be appealing:
There’s usually no underwriting or approval process. In many 401(k) plans, you don’t need to go through the normal application process that you’d find with other loans. You don’t have to say why you need the money or how you will use it. There usually isn’t a review of your credit. You simply request the loan from your eligible amount.
The interest rate may be lower than you’d find on other loans. Very often, interest rates on 401(k) loans are low, especially when compared with more traditional types of loans. This is especially true if your credit is poor and you may not qualify for low rates elsewhere. Additionally, much of the interest is repaid back into your 401(k).
The loan isn’t taxable. Generally, 401(k) plan distributions are taxable. Loans are not taxable, however, because it’s understood that the loan will be repaid through future contributions from your paycheck. You also avoid the early distribution penalty if you’re under age 59½.
Why a 401(k) Loan May Not Make Sense
Despite all the reasons listed above, there are also some consequences of a 401(k) loan that might make you think twice:
You remove assets from your tax-deferred account. Remember, the purpose of your 401(k) is to save money for retirement. The plan’s tax-deferred treatment helps you do that. To maximize the benefits of tax deferral, however, you have to have assets in the plan. If you remove assets through a loan, those funds won’t be eligible to grow tax-deferred until the loan is repaid.
You repay the loan with after-tax dollars. Your normal 401(k) contributions are pretax—that is, they’re deducted from your pay before you pay taxes. They then grow tax-deferred, and you pay taxes on your plan distributions.
However, your loan repayments are made with after-tax dollars. That means you pay taxes on the funds, then make the loan repayment. Once in the plan, the repaid funds grow tax-deferred. However, you still have to pay taxes on those funds for future distributions. That means your loan repayment funds are essentially taxed twice.
Your loan could turn into a distribution. What if you fail to repay your loan? Or what if you leave your job before the loan is repaid? In that case, your loan turns into a distribution and becomes taxable. Additionally, if you’re under age 59½ you will likely also face the 10 percent penalty on the distribution.
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. Tommy Mai Financial can help you analyze your needs and develop a strategy. Let’s connect today.
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