6 Reasons you should never take out a 401(k) Loan

6 Reasons you should never take out a 401(k) Loan

Almost everyone goes through financial challenges at one point or the other in their lives. During those dire circumstances, most people typically turn towards their retirement nest egg or the employer-sponsored 401(k) account to take a loan. However, this idea of borrowing money from your largest pool of saving could be an expensive one. The fundamental concept to save for retirement is to spend those golden years peacefully and raiding retirement savings early will deplete your savings and defeat the entire purpose. 

While tapping into your employer-sponsored 401(k) account and the idea of repaying yourself, may seem like a smart financial move, but unfortunately, it is not the case. In fact, taking a 401(k) loan will not only hurt your future savings, but you may also miss out on the magic of compounding interest. 

Why you shouldn't take a 401(k) Loan?

  1. You will be charged interest and other fees
  2. You end up putting your contributions on hold
  3. Default to pay on time can lead to higher tax liability
  4. You are at a high risk if you quit or lose your job
  5. Incur double taxation
  6. Your monthly paychecks are squeezed

If you are considering borrowing money against your 401(k). Wait and think twice! Read this blog to know the top reasons why you should hold on to your urge maybe not dip into your retirement account. 

  1. You will be charged interest and other fees

    One of the top reasons people tend to get a loan from 401(k) is because of its low-interest rate. Although you will be borrowing money from your retirement account, you still need to pay back the borrowed money to yourself at an interest rate specified by your employer within a five-year period. However, the only exception to a more extended repayment period is when the borrowed money is used for making a down payment for your primary home.

    Although a loan from 401(k) is penalty-free, it is usually disbursed without any loan application process but remember that most plans charge some additional setup or origination fee and administration cost (almost $75) regardless of the loan amount which directly goes out from your retirement account. 

  2. You end up putting your contributions on hold

    If you borrow money from your 401(k) account, be ready to put your contribution on hold since some plans do not allow you to make any additional contribution until the outstanding loan is completely paid off.

    Due to such provision, you will not only miss out on your contributions but will likely forfeit your employer’s matching contributions towards your retirement account. All this eventually will put your tax-deferred retirement savings on hold. Borrowing money from one’s 401k account can significantly reduce the amount of wealth one could have otherwise generated. 

  3. Default to pay on time can lead to higher tax liability

    When you take a 401(k) loan, you must ensure that you clearly understand the repayment rules (which is within five years) and adhere to the payment schedules which is usually once per quarter. Keep in mind that in case you do not stick to your repayment plan or muddle with your payment schedule, then the entire outstanding amount of your loan becomes taxable. In addition to this, if you are still under 59 1/2, then you will also have to pay the federal and state taxes (tax brackets will depend according to the state where you live) on the withdrawn amount plus a 10% penalty for early withdrawal – which turns out to be a huge tax liability.

  4. You are at a high risk if you quit or lose your job

    This is one of the more practical reasons why you should stay away from borrowing cash from the 401(k) account. If you change your job or quit your employer for any reason, you typically have to repay the outstanding loan immediately or within 90 days or as mandated by the employer. Most companies will alert the IRS to charge taxes and penalties if you do not pay the outstanding dues within the stipulated time frame. This means that unless you clear your outstanding dues you are trapped with your current employer and may also have to let go of a better opportunity which could have been otherwise beneficial for your career growth.

  5. Incur double taxation

    Borrowing money from 401(k) may sound simple, but it has a downside to it. You end up paying double taxes to the government. First, when you repay the amount back to your retirement account, you actually pay the after-tax amount and not the pre-tax which you were used to paying earlier. Second, when you withdraw your funds after your retirement, you will once again be forced to pay taxes on the same money.

    The reason that you are double taxed is because the money in your account is a combination of both your pre-tax contributions (which you have made) plus after-tax loan repayments and there’s no distinction between the two. So, if you are still thinking of taking out cash from your retirement funds, then be ready to pay taxes twice – when you put the money in your account and when you take your money out. 

  6. Your monthly paychecks are squeezed

    Most plans require you to start repaying the loan through an automatic paycheck deduction which begins from the next pay itself. Repayment of your loan will automatically reduce your take-home salary and possibly more than the pre-tax amount that you were contributing to your retirement plan before.

Bottom line

Money is one of the common everyday stressors in life. Difficult financial times happen to all of us. Perhaps, when unexpected expenses and circumstances come out of nowhere to knock us down, taking a loan from 401(k) account can be pretty tempting. However, keep in mind that despite your situation, borrowing money from your 401(k) account is one of the worst strategies you can make in your retirement plan. As far as possible, avoid taking out away money from 401(k) account and keep these considerations in mind before you put your future retirement at risk. 

Saving money is crucial – it is a skill that requires practice and commitment. It is essential to start saving money and build an emergency fund so that you can handle your unexpected situations in a better way. Take some time to outline an excellent financial strategy by consulting financial experts so that you can sail through such difficult times. 

Are you going through some dire financial situation and need money? Wait no more! find a financial advisor to know the right strategy to move ahead.

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