If you’re like many Americans, your 401(k) plan may be your largest retirement asset. A 401(k) plan is a tax-advantaged tool designed to encourage long-term savings. As long as the funds stay in the account, the growth isn’t taxed. This allows your funds to compound more quickly and can help you accumulate a substantial balance in a shorter amount of time.
Withdrawing funds from the plan before you reach full retirement age is generally discouraged and can incur steep penalties. While most 401(k) plans don’t allow active participants to make withdrawals, many do allow you to take loans. This may seem like a tempting option when you’re faced with a financial emergency or want to fund a major expense such as a home renovation, vacation or wedding. Taking a loan from your 401(k) can have long-term consequences, however, and may not be the wisest course of action.
If you’re thinking about taking a loan from your 401(k), be sure to weigh the pros and cons and give careful consideration to your choice. Below are a few things to keep in mind as you make your decision:
Benefits of a 401(k) Loan
It’s easy to get one. Unlike other types of loans, there’s no approval or underwriting necessary with most 401(k) loans. And there’s usually no credit check involved. You don’t have to go through an application process and explain to the bank why you need the money or what you intend to do with it. You simply request a loan.
You may get a more favorable interest rate. With 401(k) loans, the interest rate may be much lower than the interest rates on credit cards, home equity loans or other lending sources. This may be especially helpful if your credit is poor. Additionally, the interest you pay is paid back into your 401(k) account.
The loan distribution isn’t taxable. Usually, you have to pay taxes on 401(k) distributions. You might also potentially face a 10 percent early distribution penalty if you’re under the age of 59½. With a 401(k) loan, however, you avoid having to pay the income tax and potential penalty fee because you are technically borrowing the money rather than withdrawing it.
Disadvantages of a 401(k) Loan
Your savings will take a hit. When you take a loan from your 401(k), you’ll be removing a potentially sizable chunk of your assets from the account. The funds you withdraw for the loan will no longer continue to benefit from tax-deferred growth until the loan is repaid. In a sense, this defeats the whole purpose of the 401(k) plan and will likely have a negative impact on your retirement funds, as it will diminish your ability to accumulate savings.
Loan repayments are taxed twice. When you make normal contributions to your 401(k), those contributions are made with pretax dollars, which basically means you get a beneficial tax deduction. This is not the case with loan repayments, however, as you will have to repay the loan with after-tax dollars. When you withdraw those funds from your plan later in life, you’ll have to pay taxes on them again.
Your loan could become a taxable distribution. A variety of circumstances can cause your loan to be considered in default. If you don’t repay the loan, or if you leave your job before the loan is repaid, the loan then becomes a withdrawal. If this happens, you will then have to pay the distribution tax and possibly also the 10 percent early distribution penalty, depending on your age.
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 Fenton Financial Services. We can help you analyze your needs and develop a strategy. Let’s connect today.
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