The 401(k) plan is known to be one of the most cost-effective and tax-advantaged savings vehicles for your retirement. What’s more, it doesn’t only serve as an investment, but also as a financing option.
401(k) contributors can tap a portion of their investment on a tax-free basis, so long as it is allowed by their retirement plan. If it is permitted, they must repay their loan with interest. This is generally a better way to make use of their contributions than opting for early withdrawal, which is usually laden with prepayment penalties.
However, just because you can take out money from your 401(k) account doesn’t mean you should. While its advantages are great, there are potential downsides that you must carefully consider. Here are the pros and cons of borrowing from a 401(k) savings plan.
There is no lender when you take out a 401(k) loan. You are borrowing money from your account. Hence, there are no credit checks, years of income tax returns submission, nor is a rigorous loan approval process needed. Even 401(k) contributors with poor credit scores can easily and quickly request for a 401(k) loan.
The only thing you have to do is to communicate with your 401(k) administrator and fill out loan paperwork. The document will verify the withdrawal amount, interest rate, repayment terms, and the account where the funds will be deposited.
The traditional verification process usually takes a little time, so expect to receive your funds within about a week. Nonetheless, other loan requests can be made with just a few clicks online, yet rest assured it’s with total privacy. Nowadays, many 401(k) plans are opting for debit cards, through which multiple small amounts of loans can be made instantly.
You can use a 401(k) loan however you want and repay it in five years. While a longer repayment timeline makes repayments reasonably priced, a shorter one like a five-year amortizing repayment schedule keeps your financial status in check with fewer debts and ensures your contributions to grow.
Repayments are made the same way you pay in your 401(k) contributions—automatic payroll deductions. You have to pay off the interest back to your account at a rate specified by your 401(k) plan. That said, depending on what will happen in the market, repaying a 401(k) loan with interest and on time can be non-taxable. This can positively influence your finances.
Taking out a 401(k) loan can leave you with more in the account than otherwise. Similar to any regular bank loan statement, your 401(k) plan statements will show your account’s credit and outstanding principal balance.
Double-taxed + 10% Penalty
Let’s say you would not take out your 401(k) savings as a loan. With the plan, your money will earn a tax-deferred interest and will be subject to tax just once. The bottom line is that a tax-deferred account like a 401(k) plan allows you to avoid paying income tax, which is why 401(k) is one of the tax-advantaged investments.
Conversely, a 401(k) loan is repaid with after-tax dollars, while you initially contributed in pre-tax dollars. Keep in mind that your 401(k) repayment is not interest-free and isn’t tax-deductible. You’ll also be taxed twice and this can get costly, depending on your tax bracket.
Put simply, what you’ll have to put back into your 401(k) account is the borrowed money and its interest rate (specified in your plan) plus income tax within five years. Once you take out your 401(k) funds as a retiree, you’ll be taxed once more.
You also want to repay your loan on time as required. If you’re younger than 59 ½ by the time you take out your 401(k) fund, the defaulted loan balance will be subject to a 10% federal penalty tax on early 401(k) distributions. This can greatly hurt your financial health.
Limited Borrowing Amount
Two factors limit the amount you can take out from your 401(k) funds; first is the legal limit, and the second is your vested balance, whichever is less.
Firstly, if your 401(k) plan allows loans, the Internal Revenue Service (IRS) typically sets the maximum loan amount at $50,000. Secondly, you can only borrow 50% of your vested account balance. Your vested account balance refers to your total contributions in the 401(k) plan, but excluding your employer’s matching contributions and profit-sharing.
If you need an amount that is more than the legal limit or vested account balance, unfortunately, you have to look for and apply to other financing options.
It’s generally better to borrow your 401(k) funds at lower interest, as opposed to paying a combination of an income tax and a 10% early withdrawal penalty. Having said that, it’s entirely up to your circumstance whether the advantages of a 401(k) loan outweigh its downsides.
Tiffany Wagner is an aspiring financial advisor. She enjoys the ever-changing financial industry. You might see her commenting, creating, or collaborating any content about finance in the digital world.