Ubiquity
Free Consultation 855-401-7253

Tag: 401k loan

At first glance, borrowing money from your 401(k) plan may seem the easiest, cheapest, and most sensible way to get the funds you need for a major purchase (like a new home or a car), to consolidate other debt, or for any other reason.

After all, it’s your money. You don’t need to fill out any lengthy forms or reveal personal credit information, the interest rate is usually lower than a bank or lending institution, repayment is easy, and you’d be paying the money, plus interest, back to yourself.

In some cases, this may be true if you really need the funds and don’t have any other suitable alternative. But there are drawbacks to borrowing from your retirement plan that can have a major impact on your future by limiting the amount available to you at retirement.

You lose the compounding advantage.

One of the major advantages to saving in a 401(k) plan is the ability of your money to compound on a tax-deferred basis. Over time this can be a powerful tool in building funds for your retirement. Borrowing from your account slows that compounding growth and you lose the time value of the money you borrow. The amount you borrow from your 401(k) account immediately stops earning whatever investment returns you would earn if it remained invested in the available funds.

Paying yourself interest isn’t that good a deal.

Your loan repayments are made with after-tax dollars. But that money is being paid into a tax-deferred plan account. When you are ready to retire your distribution (including your loan repayments) is considered a taxable event. This means your 401(k) loan payments are taxed twice. In addition, a loan from a retirement plan is considered a consumer loan and the interest is not tax deductible, as it would be for a home equity loan.

The disaster of default.

Perhaps the most compelling reason not to borrow from your 401(k) plan is what can happen if you terminate your plan with an outstanding loan balance–or if you are simply unable to make your payments. If you terminate your plan for any reason while you have an outstanding loan, the remaining loan balance is due immediately. If you can’t afford to repay the loan in full, the entire outstanding principal becomes taxable and is deemed to be a distribution.

This can spell disaster.

Not only will you have to pay a tax on the distributed amount at your regular tax rate you will also be hit with a 10% non-deductible Federal tax penalty and a state penalty if the state you live in has one (if under age 59½). Plus, depending on the amount it adds to your taxable income, the loan distribution may actually push you into a higher tax bracket meaning your The additional costs created by a loan default can be financially devastating.

Of course, it’s still comforting to know that if the need arises you do have access to your 401(k) funds. But if you consider taking a loan against your retirement, be sure to take all the consequences into consideration.

 

Want to learn more?

Check out this jargon-free glossary to 401(k) loan terms

Watch our retirement expert Andrew answer your 401(k) loan questions

This week’s question comes from Casey who asked whether you need a spouse’s consent before taking a loan from your 401k.

While we always stress the importance of leaving your money in your retirement account, sometimes unforeseen expenses arise where you need to borrow or loan yourself money. Here, we answer Casey’s question and give some other great tips on the deal with taking a loan from your 401k!

Get more on 401k by downloading our Definitive Small Business 401k Guide

What can you do if you need cash, don’t have adequate savings, and taking out a loan from a bank or friend isn’t an option? What if you are trying to buy your first home and are coming up short for the down payment? Many people turn to a 401k loan, that allows you to borrow the money you’ve already invested.

While it is your money, it is important to note it takes people about three weeks to receive their loan. Plus, before you can get a loan it has to be approved by both your 401k provider and your employer. So if you need money right away, this might not the best option for you.

Additionally, since this is a workplace benefit offered through your current employer, it’s not wise to take out a loan if you plan on leaving your job in the next few years. Here are some things to think about:

1. Personal vs. residential loans

A residential loan can be used for purchasing your first home or primary residence. Your employer and even the IRS may be more lenient with this type of loan and give you up to 15 years to pay it back.

A personal loan can be used for almost anything, including student debt, a new car, healthcare expenses, etc. You may only have five years to pay off a personal loan.

No matter what type of loan you take, the minimum you can withdraw from your 401k is $1,000, and the maximum is half of your current balance or $50,000.

2. Interest

You may be thinking, why do I have to pay interest on a loan I took from myself? The IRS wants you to pay interest to mimic the gains your 401k could have made if the money had stayed invested. Your interest rate is calculated by taking the prime rate – the interest rate that banks charge to their most credit-worthy customers – and adding 1 to 2 percent, depending on your provider.

3. Fees

In addition to paying your interest, you will pay some hefty fees. If you are taking a five-year loan, you could pay upward of $500 in fees on top of what you initially borrowed. Why?

First, there is likely an administration fee (sometimes called an “origination fee”) that goes toward drawing up your paperwork, writing the check and transferring your money. After that, there is an annual administration fee to cover the maintenance of your loan.

4. Repayment schedule

Loans are repaid the same way you contribute to your 401k – automatically and through your paycheck. Since this is a workplace benefit and not built to be easily accessible, most providers will only let you have one active loan at a time. This means you need to completely pay off one loan before taking out another from your 401k.

5. Defaulting

Defaulting is when you can’t make your loan payment when it’s due. Like any default, this can have serious financial implications. How can you default if your repayments come directly from your paycheck? One way is if your employment is terminated and you are no longer receiving a paycheck. If that happens, you are required to pay back the full amount of your loan within 60 days, and on top of that, your balance will be taxed and you could even face an early withdrawal penalty if you are under the age of 59 ½.

6. Loan modeling tools

This resource from Bankrate allows you to see how a 401k loan will impact your paycheck and retirement plan. Most importantly, make sure you are prepared for a lower monthly income so you can stay on track to meet any long-term financial goals.

Download Ubiquity’s Definitive Guide to Small Business 401k

© 2018 Ubiquity Retirement + Savings
1160 Battery Street, Suite 350, San Francisco, CA 94111 / Support: 855.401.4357

© 2018 Ubiquity Retirement + Savings
1160 Battery Street, Suite 350, San Francisco, CA 94111 / Support: 855.401.4357