Taking a loan against your 401k plan may feel like a safe option in situations of financial need. A loan against your 401k is not a traditional loan in the sense that there is no lender (they are your assets) and the loan is not measured against your credit score.
Those two benefits do not outweigh the potential consequences of taking out the loan. The largest reason for investing in a 401k is tax-deferred growth. If you take money out of your account, it is no longer growing. While 401k plans differ from company to company, most companies don’t allow contributions while a loan is out against the account. If contributions are not being made to the account, then the employer is not providing a match. The low-interest rate of a 401k loan is easily negated by the opportunity costs that come from missing contributions and employer matching.
In addition to the pausing of contributions, you may also be double taxed for the loan. You will pay taxes on the money that you loan out to yourself and then you will be taxed again when you withdraw funds for retirement.
A loan against your 401k can also become a slippery slope that can lead to some poor financial decisions. If you have reached a point where a loan against yourself is your best—or worse—only option, then it may be time to look for a deeper root cause. If you cannot afford your lifestyle, then taking a loan from your future self is not going to make matters better. A 401K is a long-term financial tool, don’t let short-sightedness steal from your future goals.
A typical plan will allow for a 5-year repayment period for the loan but because the rates are low and you are the creditor, it may be easier to ignore this timeline which only increases the lost opportunities. If you leave your job or are terminated in that time period before paying back the loan, it becomes immediately due. Otherwise, it can be considered a taxable distribution. If you are under 59 ½, you will pay a 10% penalty plus income tax on the distribution.
Rates have been historically low which has made the prospect of a 401k loan less attractive, but as uncertainty begins to swirl and rates grow, some may look to their 401k as an attractive option to help get through some hardships. If you find yourself in this situation, please contact your tax professional first because these decisions will have tax implications that will affect you now and in the future. If you are ready to set yourself on a path to financial independence, contact our office to begin a comprehensive financial plan. Together, we can take a look at your existing assets, your income, and your lifestyle then create a plan that puts you on a journey to achieve your financial goals.
By Michelle Boisvert