If you’re like many working Americans, your 401(k) may be one of your largest financial assets. The combination of regular elective contributions and matching employer contributions can help a 401(k) balance accumulate quickly.
One of the most powerful features of a 401(k) is the fact that 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 might 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. A distribution from the 401(k) may seem like the only possible solution.
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 carefully think through the consequences. Below are some important facts to guide you through the process:
Why a 401(k) Loan Could 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 not a credit check 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 often isn’t a review of your credit. You simply request the loan. If you have enough money available, the loan distribution is processed.
The interest rate may be lower than you’d find on other forms of debt. 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), rather than going to some other creditor.
The distribution isn’t taxable. Generally, 401(k) plan distributions are taxable. However, loans are an exception 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 to 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 essentially act as a deduction because they reduce your taxable income. The contributions 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 income, 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. Contact us at Foote Financial Group. We can help you analyze your needs and develop a strategy. Let’s connect today.
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