Have you ever been in a tight spot financially and were unable to borrow money from anyone? To solve this problem, one out of four people are electing to take out a loan from their 401(k). Although you have the legal option to do so, you have to be careful as too many people are withdrawing money from their 401(k) without understanding the real consequences of their actions.
Your 401(k) account should not be used as an ATM. Instead, the purpose of having a 401(k) is to allow your money to grow compounded over time so that when you are ready to retire, you will have a bundle of cash to live comfortably.
When you elect to take money out of your 401(k), you are taking away tomorrow’s funds to solve a need for today. Most financial experts advise you to avoid the temptation of taking out these funds as you should exhaust every other possible option first. It is suggested that you do so because once the funds are withdrawn, it takes some time to replace them. Additionally, while the funds are out on a loan, they are no longer growing tax-free, which is one of the fantastic features of having a 401(k). You must also familiarize yourself with the rules regarding your repayment policy as most administrators give you a specific time to repay the loan before imposing a penalty.
Here are some of the advantages and disadvantages of choosing to take out a loan from your 401(k).
Here are some of the advantages:
- You don’t need to have a great credit score in order to get a loan as you are borrowing from yourselves.
- You can borrow up to 50% of the vested balance amount.
- You can pay back the loan using a payroll deduction process.
- The processing fees in getting a loan are nominal and you get the funds quickly.
- You also get a window of up to five years to repay the loan for most plans.
- You have the option to take out a hardship loan based on an approval of the administrator and the funds won’t be penalized by the IRS under certain situations.
Here are some of the disadvantages:
- When you take a loan from your 401(k), that portion of your retirement stops growing.
- Since there are no credit checks involved, people are taking out loans for any reason and not just for emergency situations like the rule was intended.
- If you should lose your job, voluntarily or not voluntarily, the loan has to be paid within sixty days. If you fail to do so, you will be hit with a 10% penalty and when you are out of work, this is an extra level of stress that is not good for you.
- The loans have to be paid back with post-tax dollars from your paycheck, as lump repayments are not permitted.
- If you are not fully vested in your job, you can’t borrow the maximum allowed. The vested period varies from company to company, as some are three years, five years and others are longer.
- Most plan administrators will not permit you to take out a new loan if you have one outstanding.
- If the loan is not paid back within the time frame specified, this would be considered an unauthorized withdrawal and the taxes would be due on the withdrawal funds. If you are under 59½, there is an additional IRS charge in taking a withdrawal.
As you can tell from this list of advantages and disadvantages, there are some serious considerations that have to be made before electing to take out these loans. If we are not careful in taking out these loans, we won’t have much left in the kitty growing for our future.
I’m fully aware that when a financial emergency comes up and you don’t have another choice because you need funds quickly, getting this type of a loan is preferred. However, if you do, you should attempt to pay back the loan as soon as possible. In doing so, your funds can be reinvested again, ensuring you have a nice nest egg for you when you get older. The people who choose to take out these loans abusively, and there are many people who are doing so, they will be hurting themselves later on and that is when we will need the funds even more.
In closing, in a period where the economic times are highly volatile like it is currently, people have a tendency to take out more 401(k) loans than normal. In these situations, some people have abused this option by taking out more money than their emergency requires, which is negatively affecting their ability to build up a nest egg for tomorrow. I hope that in reading this article, you will be cautious in choosing to take out money from your 401(k) as the disadvantages easily outweigh the advantages on a long-term basis.