Your employer 401(k) plan may be one of your most important retirement assets. The combination of your regular contributions, the matching contributions from your employer and tax-deferred growth makes the 401(k) a powerful savings tool.
Because this is probably one of your largest accounts, you might be tempted to take cash from your 401(k) plan. Life is unpredictable, and when you face a significant financial threat, like medical bills, a 401(k) distribution might seem like the only good option.
Most plans won’t allow you to take a 401(k) withdrawal while you’re still a plan participant. However, you may be able to take a loan. Just because you can take one, though, doesn’t mean you should. Below are some of the pros and cons to help you decide whether it’s the right choice for you:
Why a 401(k) Loan Might Make Sense
One appealing aspect of a 401(k) loan is that there’s no approval or underwriting required. All you need to do is request the loan and, assuming you have enough assets in the plan to cover the loan, you are usually approved. This may make a 401(k) loan an easier option if you have challenged credit.
More often than not, the interest rate on a 401(k) loan will be lower than the rates you’ll find with credit cards, home equity loans and most other traditional types of loans. This also might make it an appealing option if you have a credit situation that would make it difficult to get approved for other kinds of loans with competitive rates.
Another potential positive is that the distribution is not taxable. People under age 59½ typically face penalties for withdrawing funds from their account early. For example, you might ordinarily face a 10 percent early distribution fee and taxes on the distribution. A 401(k) loan, however, avoids both of these costs.
Why a 401(k) Loan May Not Make Sense
One of the biggest advantages of having a 401(k) is that it allows you to grow your savings in a tax-deferred manner. That means the gains you see from your investment are not subject to taxes as long as the funds remain in your account. Once you withdraw those funds, however, they are subject to taxes.
If you take a portion of your 401(k) out through a loan, those funds are no longer in the plan to grow on a tax-deferred basis. That could slow your growth and limit your ability to hit your retirement savings goal.
Taking a loan from your 401(k) also forces you to pay taxes twice on your contributions. Normally, when you put money into your 401(k) it’s pretax, which means those contributions aren’t included in your taxable income.
Repayments on your loan, however, are made with after-tax dollars. That means you’ll pay taxes on your repayment dollars, and you’ll pay taxes when you withdraw those funds from your 401(k) later in life.
Another con of taking a 401(k) loan is that it could become a taxable distribution. Failing to repay your loan or switching jobs before you repay it will put you in default of the loan. Once this happens, it automatically becomes a withdrawal. And this means the funds are taxable. On top of that, you might also face 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. Contact us at Coventry Financial Group. We can help you analyze your needs and develop a strategy.
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