8 Things to Consider Before Taking Out a 401(k) Loan

Is dipping into your 401(k) a good way to cover other financial needs? We’ve got the facts.

A 401(k) plan is a great way to save for your retirement. You get to save pre-tax money from your pay check which lowers your income tax responsibilities for the current year. With tax deferral, possible partial employer matching and compounding interest, your savings can build dramatically over your working career.

If you have financial needs during the years before your retirement, you may be able to borrow from this account using a 401(k) loan. The question is: should you?

Illustration of man at sea, floating on a dollar sign

This decision should not be made lightly, since it can have a significant impact on your long-term financial future. Here are 8 key things to consider before taking out a 401(k) loan:

  • By definition, according to the Wall Street Journal, A 401(k) is a retirement savings plan sponsored by an employer. It lets workers save and invest a piece of their paycheck before taxes are taken out. Taxes aren’t paid until the money is withdrawn from the account.
  • You may have to repay a 401(k) loan following a fixed schedule, generally equal quarterly payments, to avoid having it treated as an early distribution. If you miss payments or stop making them, your full loan balance can be subject to a penalty – plus, possible additional taxes. This extra burden is counterproductive when you might already have current short-term financial needs.
  • You may not be able to make contributions to your retirement plan while you have an outstanding 401(k) loan. If you use the full allowed repayment term of five years, you could be missing out on that annual savings as well as the interest compounding during that time.
  • If you are not making contributions, you cannot receive any matching amounts from your employer. With many companies making contribution matches, you might be leaving money on the table during the loan period.
  • The interest you pay on a 401(k) loan does go into your account, but it is not tax deductible as a home refinance or home equity loan could be.
  • While you are borrowing from your own account, the funds may not be available for weeks or months, and you may likely have to pay an origination fee.
  • If you lose your job, the full loan balance usually becomes due within 90 days.
  • Even though you are paying interest to yourself, you are missing earning interest on the money that you removed from your account so the net interest can easily be a negative amount.

Young couple discussing using a 401(k) loan to buy their first house

With all the downsides, many financial advisors recommend looking for other sources for money so you can keep your 401(k) intact while you sort out your current financial issues. You may want to consult a financial planner for help evaluating your specific situation.

The key point to remember is that your 401(k) is intended to be a long-term investment to help you live comfortably when you reach retirement age. It’s important to make a careful decision about a 401(k) loan before putting that nest egg in jeopardy.

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