An employer-sponsored 401(k) plan can be one of the most useful tools available for retirement savings. The combination of employee contributions, employer matching and tax-deferred growth means you can generate a significant nest egg, especially when they’re compounded over a long period of time.
If you’re suddenly faced with a big financial emergency, like health care costs, you might find it tempting to dip into your 401(k) by taking a loan. While a 401(k) loan may seem like an easy fix for your financial challenge, however, it comes with some important consequences. Below are a few things to consider before you take a 401(k) loan:
Why a 401(k) Loan Could Make Sense
One of the most appealing aspects to taking a 401(k) loan is that there’s no approval or underwriting required. Generally, you simply need to request a loan to start the process. There are no credit checks. This makes it an appealing option for people who have challenged credit.
A 401(k) loan also typically has lower interest rates than credit cards and other forms of high-interest debt. This low interest rate is, again, something that might appeal to people with poor credit, who might otherwise face steep borrowing costs.
Finally, a 401(k) loan also allows you to avoid things like distribution taxes or early withdrawal penalties. Since the distribution will be repaid, it’s not taxable when the funds exit the plan.
Why a 401(k) Loan Might Be a Bad Idea
One of the biggest advantages of having a 401(k) is being able to grow your retirement funds on a tax-deferred basis. That means you can put money into the account and avoid taxes on the gains as long as the funds stay in the account. Tax deferral can be a powerful tool to help your funds compound faster.
The best way to maximize the power of tax deferral is to maximize the amount of funds you have inside the plan. If you remove funds via a loan, that’s less money you’ll have growing on a tax-deferred basis. You might be setting your retirement plan behind.
Another downside to taking a 401(k) loan is you’ll have to pay taxes on the distribution twice. Normally, when you put money into your account it is pretax, meaning you don’t have to pay taxes on the funds until you remove them from the account.
When you repay your loan to your 401(k), however, those payments are made with after-tax money. Then, when you withdraw those funds from your 401(k) later in life, you’ll be forced to pay tax on this distribution. This means, in effect, you’ll be paying taxes twice, once on the loan repayment and again when you withdraw those funds from your account.
It’s also possible that your loan could become a taxable distribution. For example, if you fail to repay the loan or leave your job, the loan is considered default. That means it becomes a withdrawal, and it might be subject to taxes and the 10 percent early distribution penalty if you’re under age 59½.
Are you considering using a 401(k) loan to fund a major financial goal? There may be better options available. Let’s talk about it. Contact us at Bridge River Advisors LLC. We can help you analyze your needs and develop a strategy. Let’s connect today.
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