Borrowing Money from Your 401(k) – Good idea? …not so much

Too many are dipping into their employer sponsored retirement plans 401(k) using the lending feature. Unfortunately, many are later faced with a tax dilemma.

Borrowing Money from Your 401(k)

For years you have put away 6% of your pay into your employer provided 401(k) retirement savings account. Your employer may have even matched 50% of your contribution. Now you want to take some of this money out in the form of a loan to help pay your bills or to buy a car. Before you take action, here are some things to consider.

Loan versus withdrawal

If you withdraw funds from a 401(k) prior to age 59 ½ you may be in for a surprise at tax time. Withdrawals are subject to income tax and often are subject to a 10% early withdrawal penalty. A better option is to consider loaning yourself the money. 401(k) loans are available for up to 50% of your account balance.

The advantages

There are many advantages of borrowing money from your own retirement account.

No immediate tax. You do not pay income taxes on the funds lent to you. If you withdraw the funds, you must pay ordinary income taxes and a potential penalty on the withdrawal.

You repay the loan. This re-establishes your original retirement account contributions for use during retirement.

Your interest payment is to yourself. Your 401(k) loan payment includes interest. This interest provides you a return on your original contributions. It is better to pay yourself interest than to pay this interest to a bank.

The disadvantages

Repay or else. If you leave your current employer you will need to repay all outstanding 401(k) loans immediately. If you do not, your remaining loan balance turns into a withdrawal subject to income tax and a potential early withdrawal penalty.

Opportunity lost. Your 401(k) loan amount is no longer invested. While your interest payments provide a small return, it usually is much lower than those available through retirement account investment options.

Less take home pay? If you wish to contribute to your retirement savings at the same level as before you took out the loan, you must make sure your retirement loan repayment does not impact your previous contribution levels.

When making the tough decision to borrow your retirement savings, remember to first consider all your alternatives. The risk of job loss and then immediately needing to repay this retirement plan loan often leads to financial hardship and an unwanted surprise at tax time.

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