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12 Things You Should Know About Borrowing from Your 401(k) Thumbnail

12 Things You Should Know About Borrowing from Your 401(k)

Melissa A. Seamon, CFP®

Senior Financial Advisor 

12 Things You Should Know About Borrowing from Your 401(k)

You’ve likely heard all the cliches a million times. Saving for retirement is a marathon and not a sprint. Keep your eyes on the prize. Slow and steady wins the race. Never touch your 401(k).

Or maybe you haven’t heard that last one, but it’s a biggie. You want your retirement plan to keep on growing; taking any withdrawals before you reach retirement age can come with heavy tax implications and consequences.  

But then you swear that your cousin Mike and his wife put a down payment on their gorgeous new house by using his 401(k). And your neighbor down the street said she used hers to help pay for her kids’ college. So, what’s the deal?

3 Reasons Borrowing from Your 401(k) Should Be Your Last Resort

1. Paying interest and taxes: Most plans allow you to take out a loan up to 50% of your vested amount or up to $50,000, whichever is more. But you must pay it back with interest, and you are paying it back with after-tax dollars. So, you are losing out on your tax savings and then also paying interest on top of that.

2. Pausing contributions: This depends on your employer’s plan, but you will likely have to pause your contributions while you repay the loan. This means that you will not only lose out on that length of savings time but also any employer match during that time as well. Typically, you must repay 401(k) loans within five years. If those five years are during some of your highest earning years, that could hit you even harder.

3. What happens if you leave that job: If you leave your job for any reason before you have fully repaid your 401(k) loan, you will likely have to repay the remaining balance in a very short time, which can put you in a financial hardship. If you default, then you will have to pay taxes plus a 10% penalty if you’re under age 59.5. 

5 Other Funds You Should Consider Instead of a 401(k) Loan

Before you consider taking out a 401(k) loan, consider these five other sources of funds:

1. Savings account: How much have you put away for a rainy day in your savings account? Savings accounts are much more easily accessible than 401(k)s.

2. Emergency funds: If you’re looking to take money out of your 401(k), then this is definitely an emergency. So, whether you have it tucked away in a separate savings account or (hopefully not) under your mattress, it’s time to dig into your emergency fund instead.

3. Other funds you’ve forgotten about: Do you have any CDs (certificates of deposits) that are about to mature or savings bonds from your grandmother?  

4. Other investments: Do you have any mutual funds or other investments that are not retirement accounts? Taking withdrawals from these accounts will have some tax implications, but will be much better moves in the long run than touching your 401(k).

5. Personal loan: Depending on the interest rates, taking out a personal loan or even a home equity loan can be a better idea than pulling money out of your retirement account. Do some research and compare rates.

Top 4 Reasons People Do Borrow From a 401(k)

1. Home purchase: Like saving for retirement, buying a house is a big financial milestone and one that can make a big difference in a person’s or family’s life. And a down payment for a house is probably the #1 reason people take out a loan from a 401(k). Often, the interest you pay on the 401(k) loan is about the same from a bank, and because you are using your own money, the 401(k) loan does not affect your credit score. But you cannot take tax deductions for interest payments to your 401(k) loan like you can for mortgage interest payments.  

2. Tuition payments: The cost of college has become egregious which you already know if you’re paying attention to recent headlines about student loan debt,  especially for millennials. Many parents and former students now in repayment  are taking out loans from their 401(k) because of the convenience and lower  interest rates. Again, you cannot take tax deductions like you can for student loan interest payments. And parents, don’t risk your retirement to help your kids, it's just a bad idea.

3. Payoff high-interest debt: If you have credit cards with interest rates over 15% or other high-interest debt, borrowing money from your 401(k) to get that burden off your back is certainly attractive. The interest rates for repaying your 401(k) loan will likely be at least 3x less. But again, just be sure to exhaust all other options before you take this leap. Having high-interest debt can set you back financially, but so can derailing your retirement savings.

4. Unexpected hardship: When medical bills or a loss of a job hits your family, things can get tight quickly. The pandemic was a huge demonstration of this. Many families had to face exhausting their checking, savings, and emergency funds and possibly even maxing out credit cards. So, seeing a huge chunk of money sitting untouched can be very tempting when you’re in survival mode, which is understandable.

If you do decide to borrow from your 401(k), then  

  • Don’t borrow more than you need,  
  • Have a plan in place for repayment,  
  • Get expert help from a financial advisor to help navigate this and every step of  your investment and retirement journey.

We understand that when life throws you financial lemons, your 401(k) might seem like making lemonade of a tough situation. But we also know how hard it can be to catch up with lagging retirement savings.  

If you are in need of a financial ally, we encourage you to visit our site, learn more about our services, and see if we could be a good match. We best serve clients looking for exceptional client service, who value a long-term partnership, and have minimum of $500,000 in investable assets.

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