401(k) Loans: Know what you’re getting into
Taking out a 401(k) loan may seem an easy route to needed cash. Neither income level nor credit score will come into play, and the paperwork is fairly simple. But it’s important to understand the downsides. This article explains some of the financial disadvantages that can be involved with a 401(k) loan — particularly if the borrower suffers a job loss during the payback period.
People often find themselves in need of cash on short notice. Sometimes the need is an emergency, such as a medical problem. But, other times, it can be an opportunity — such as an amazing travel experience or the chance to start a business.
Whatever the circumstance, taking out a 401(k) loan may seem an easy route to needed cash. But, you must understand what you’re getting into.
Not an easy decision
The first thing you need to know is whether you can borrow at all. Although plans aren’t required to allow loans, many do permit participants to borrow against their balances. But, under strict IRS rules, loans are generally limited to the lesser of $50,000 or 50% of your vested balance.
If loans are permitted, you won’t face many roadblocks. Neither income level nor credit score will come into play. The paperwork is fairly simple. And interest rates on 401(k) loans are typically low. Plus, you’ll be paying that interest to your own account rather than a bank.
But don’t let ease of borrowing mislead you into thinking this is an easy decision. Consider a 401(k) loan only when you need the money immediately and there are no better alternatives. Why? Because a 401(k) loan isn’t without risk.
Risks to consider
The most obvious risk of a 401(k) is that you’re cracking into your own nest egg. Borrowing funds invested in your plan means less potential compounded growth — even if you pay the loan back with interest.
The nest-egg damage will be exacerbated if your employer prohibits contributions to your 401(k) while you have an outstanding loan. First, you’ll lose out on what the pretax contributions’ additional compounded growth potential would have been. Second, your current taxable income will increase. And if your employer matches contributions, you’ll lose out on that, too.
Another consideration is job security. If you’re laid off or terminated, your 401(k) might require that you pay back the loan within 30 or 90 days. Even if you keep your job, loans generally must be repaid within five years (unless used for a personal residence).
Should you fail to repay, you’ll incur income tax liability as if you’d taken a distribution. Borrowers younger than age 59½ will likely suffer an additional 10% early withdrawal penalty.
Before you sign
A 401(k) plan is valuable for many reasons, the ability to take out a loan being just one. But be sure to consider the alternatives first (such as a home equity loan) and assess the risks before you sign.
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