The 401(k) plan, which is an employer sponsored plan, was designed to be a simple tool to help employees start saving for retirement. While each company plan varies, there are provisions that many plans have in common - one of those being the option to take a loan out on your 401(k). While you have the capability of withdrawing your money, policy makers have implemented laws to make taking money out of your 401(k) a disincentive. Before taking a loan out on your 401(k), there are a few things that you should consider.
Double Taxation!
Nobody likes paying taxes, and if you do, you have the option to pay them twice by taking out a 401(k) loan! When taking a loan on your 401(k), there are two times at which you will have to pay taxes on your 401(k) money. If you are contributing money on a pre-tax basis, you will be taking a loan out on pre-tax money, and paying back the loan, as well as interest, with after tax money. It is important to understand that will you will not pay taxes twice on the principal amount of the loan, but rather pay taxes twice on the interest of the loan. First, you will be paying interest on the loan with after-tax money, and second, you will have to pay taxes on that money again upon taking a distribution further down the road.
Missed Earnings Opportunities!
When you borrow money from your 401(k), you are removing the money from your account, which also means you are taking your money out of the market. Taking your money out of the market can negatively impact your portfolio and performance, as you are forfeiting the opportunity to generate potential gains, and the power of compounding interest begins to diminish. IRS regulations allow you up to 5 years to pay off the loan in its entirety, unless the loan was being used to purchase a primary residence, in which case you would have more time. If you are unable to contribute to the plan, and in addition if your employer has a matching contribution set up with the plan, you will not only be missing out on your contributions, but also the “free money” that your employer is willing to contribute.
Additional Fees and Severe Potential Tax Consequences if You Default
Upon taking your loan, you may be subject to a loan origination fee of upwards of $75. As you begin making payments on your loan, defaulting on the loan is something you want to avoid completely. So what exactly happens if you default on the loan/stop making payments? When you file taxes for that year, your distribution will have to be reported as taxable income (Form 1099-R), and if you are under age 59.5, you may be subject to a 10% early withdrawal penalty.
The focus on this article is not to bash 401(k) loans, but rather to inform you of the potential risks that come with taking a loan against your 401(k). Taking a loan may be easy and convenient, and in some cases, it may be the one of the better options available. Yet, looking at this from a retirement perspective, it is important to emphasize that there could be long-term consequences for removing money from your retirement account. Between double taxation and cutting into the potential long-term gains/compounding interest, you may be cutting into the ability to reach your long-term retirement goals. Before taking a loan, it is recommended that you do your research, explore your options, and seek advice from a financial professional to ensure that using this retirement money is the best fit for your financial situation.