Why You Should Never Borrow from Your 401(k)
Your 401(k) is supposed to be your nest egg for your retirement years. So why would you want to borrow against your future?
Well, for many, borrowing from a 401(k) plan might seem like a great way to pay off debt or help you make a large purchase. However, there can be consequences. You may think you’re just borrowing from yourself, but you’re actually borrowing from your future self. This means compromising all those happy years in retirement you dream about. So if you’re thinking of taking a loan from your 401(k), here are some things to consider first.
You’re Losing Money
Interest rates on 401(k) loans can be very appealing. You have the ability to borrow your own money and pay interest to yourself rather than a bank. While this may seem like a great idea, not only are you missing out on the compound interest your 401(k) would be earning, but historically the market has made money. This means, when you take out a loan you’re selling your assets. When you go to repay your loan, you may be buying shares in a fund at a higher price.
Additionally, if you’re not able to repay your loan within the time frame allowed, your loan will be considered a withdrawal. This mean you will pay a 10% penalty if you are under the age of 59 ½.
You Pay Taxes Twice
For a traditional 401(k) plan, you contribute with pre-taxed dollars. You won’t pay any taxes until you later withdraw from your account as ordinary income. Those looking to borrow from their fund, will actually be taxed twice. This is because you’re paying back the loan with after-tax dollars. Later, when you wish to withdraw (after age 59 ½), you will be taxed again.
You Can’t Contribute Until the Loan is Repaid
Many 401(k) plans will not let you continue to contribute money until you have repaid the full amount you have borrowed. Since most loans are five years long, this could mean five years of failing to add to your retirement fund. You will miss out on the growth and interest you would have accumulated had you left your money where it was.
Increased Risk with Employer
By taking a loan on your 401(k) retirement fund, you run the risk of putting yourself in hot water with your job. In many plans, your employer may take money directly from your paycheck to help repay your fund. Keep in mind your fund, in this case, is now being paid back with after-tax dollars.
If for some reason you stop working or you’re let go by your employer, you may be required to repay the loan within 60 days. If you cannot make the payment, your loan will be considered an early withdrawal. You’ll now have to pay a 10% penalty as well as income taxes.
You’re Robbing Yourself to Pay Someone Else
If you use your 401(k) to pay off debt, you are essentially just moving your debt around, as you will still need to repay a loan. Some think this may be better than paying a bank, as interest rates may be lower. However, you still may be losing more than you think. Even if you pay your loan back on time, you will have lost out on maximizing the effects of compounding interest.
Taking a loan on your 401(k) is rarely a good idea. While it may seem like a good option for availability to immediate funds, you’re only hurting yourself. If you’re struggling with finding ways to pay off debt or having trouble freeing up cash, consider giving Tayne Law Group a call. There may be a better option to get the funds you need without borrowing from your future.