An employer-sponsored 401(k) plan can be one of the most useful tools at your disposal for saving for retirement. The combination of employee contributions, employer matching and tax-deferred growth can help you generate a significant nest egg, especially when the growth is compounded over a long period of time.
If you’re suddenly faced with a big financial emergency, like health care costs or home repairs, you might be tempted to dip into your 401(k) by taking a loan. While a 401(k) loan may seem like a quick solution for your financial challenge, it can come 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 of taking a 401(k) loan is that there’s usually no approval, credit checks, or underwriting required. Generally, you simply need to request a loan to start the process. This can make 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 may face high borrowing costs on other types of loans.
Finally, a 401(k) loan is treated differently than a 401(k) withdrawal from a tax standpoint. With a 401(k) loan, you avoid things like distribution taxes or early withdrawal penalties as long as you stick with the loan repayment schedule. Since the distribution will be repaid, it’s not taxable when the funds exit the plan.
Why a 401(k) Loan Might Not Be the Right Strategy
Despite the benefits listed above, there are many important reasons why a 401(k) loan may not be the right choice for you. First, your loan may limit your ability to save for retirement. 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 Carstens Financial Group. We can help you analyze your needs and develop a strategy. Let’s connect today.
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