If you need cash, accessing assets within your 401(k) plan may be a tempting idea. It is very important to remember however, that the purpose of a 401(k) is to save for retirement. Take money out of it now through a distribution and you will risk running out of money during retirement while incurring taxes and penalties. Typically, the 401(k) platform offers a unique feature that allows for periodic borrowing to access the funds without a full distribution. In the event you are facing a financial emergency — for example: your child’s college tuition is due and your 401(k) is your only source of available funds — borrowing money from your 401(k) may be your only option.
Make sure your plan allows for loans by checking the Summary Plan Description (SPD) or call to ask your plan administrator directly. Initiating a loan usually has little paperwork and modest processing fees.
You can borrow up to $50,000 or one-half of your vested balance, whichever is less. For example, if your account value is $20,000, you can borrow up to $10,000.
Typically, you have to repay money you have borrowed within five years by making regular payments.
What are the Advantages of Borrowing Against your 401(k)?
- You can avoid taxes and penalties by paying back the loan on time.
- Interest rates are consistent with similar bank loans, regardless of your credit.
- Usually the interest you pay on borrowed funds is credited to your own plan account; so pay yourself, not the bank.
What are the Disadvantages of Borrowing Against your 401(k)?
- Potential taxable distributions and penalties. Be sure to follow the repayment requirements for your loan because the money that is not repaid will be considered a taxable distribution and borrowers under age 59½ may also owe a 10 % federal penalty.
- Accelerated Loan Repayment: If you leave your employer’s service with an outstanding loan, you have to repay the remaining loan balance according to documents governing your employer’s plan, but no later than the end of the calendar quarter in which the unpaid repayment was due. In addition , plan participants had 60 days to roll over a plan loan offset amount from a 401(k) or 403(b) plan account to an eligible retirement plan that accepts the rollover. Starting 1/1/18, the new Tax Cuts and Jobs Act extends this time period until the due date for filing the participant’s federal income tax return (with extensions). This new rule applies only to plan loan offset amounts resulting solely from the participant’s termination of employment or the employer’s termination of the plan. Loan interest is generally not tax deductible.
- Your plan balance is reduced by the loan amount, creating an opportunity cost of lost investment return on that portion of the account.
- Loan payments are made with after-tax dollars.
Remember, borrowing from your retirement plan should be a last resort. You risk taxes and penalties, as well as the loss of compounding interest and investment return due to a smaller nest egg.
This short, small dose, educational video highlights the advantages and disadvantages of a 401(k) Loan:
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