Sometimes life throws you a curveball, and you find yourself in a financial jam that requires some quick cash. Taking a loan from your 401(k) plan sounds like an easy solution. After all, you’ll be borrowing from your own retirement account and paying yourself back with interest. Sounds reasonable enough, right? Not always.
Borrowing from your 401(k) can be harmful to both your short- and long-term savings goals. Here’s why.
- When you take out a loan from your 401(k), you’re borrowing money that hasn’t been taxed yet. But when you pay back the loan, you’ll be doing it with after-tax dollars that will be deducted from your paycheck. Years later, when you withdraw that paid-back money as distributions from your 401(k), it will be taxed again. That means you will be taxed twice on your retirement savings!
- You will likely stop contributing to your 401(k) plan. Why? Because the loan repayments will reduce your take-home pay, giving you less cash to work with each month. Moreover, if you stop contributing pretax dollars to your 401(k), your taxable income will increase, which could put you in a higher tax bracket. And what does that mean? You guessed it: higher taxes. So taking a loan from your 401(k) not only halts your retirement savings momentum, but it could also lead to a higher tax bill.
- If you leave your job and haven’t finished repaying your loan, you may owe taxes and penalties. Your former employer could require you to pay off the loan’s outstanding balance. If you can’t do that, the balance could be reported to the IRS as a distribution, and distributions are taxable. But, wait, there’s more bad news. If you’re younger than 59½, you would have to pay an extra 10 percent penalty to the IRS on that distribution!
- When you withdraw money from your 401(k), it is no longer being invested. And when you’re not invested, you’re not earning interest and benefiting from any potential market gains. This could translate into your having less money when you retire.
Circumstances may leave you with no alternative but to borrow from your 401(k) plan. But if you can, try to find a way to get the cash you need today other than borrowing it from your future.
If you have questions about the potential impact of taking a loan from your 401(k), please reach out to me. I am happy to help in any way.
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