For years you have put money from your pay into your employer provided 401(k) retirement savings account. Your employer may have even matched part or all of your contribution. Now you wonder if you could take some of this money out of your 401(k) in the form of a loan. Before you take action, here are some things to consider.
Loan versus withdrawal
If you withdraw funds from a 401(k) prior to age 59 ½, your withdrawal may be subject to income tax and could also be subject to a 10% early withdrawal penalty. There are a number of situations in which the withdrawal penalty may be waived, including for disability, death, college tuition, or medical bills, to name a few.
A better option may be to consider loaning yourself the money. 401(k) loans are available for up to 50% of your account balance and may help you avoid paying income taxes and a penalty.
No immediate tax. You do not pay income taxes on the funds lent to you. If you withdraw the funds instead of choosing the loan option, you must pay ordinary income taxes and a potential penalty on the withdrawal.
You repay the loan. This re-establishes your original retirement account contributions for use during retirement, which helps avoid damage to your wealth accumulation goals prior to retirement.
Your interest payment is to yourself. Your 401(k) loan payment includes interest. This interest provides you a return on your original contributions. It is likely better to pay yourself interest than to pay this interest to a bank.
Repay or else. In most situations, if you leave your current employer you will need to repay all outstanding 401(k) loans within a very short window of time. If you do not, your remaining loan balance turns into a withdrawal subject to income tax and a potential early withdrawal penalty.
Opportunity lost. Your 401(k) loan amount is no longer invested in the market. While your interest payments provide a small return, it usually is much lower than those available through retirement account investment options.
Less take home pay. If you wish to continue contributing to your retirement savings at the same level as before you took out the loan, your take home pay will now be lower as you are making contributions AND paying off your 401(k) loan.
When evaluating whether to borrow your retirement savings, remember to first consider all of your alternatives and the positives and negatives of each option. If we can help, let us know.
Andrea L. Blackwelder, CFP®, ChFC, CDFA® and Joseph D. Clemens, CFP®, EA are the founders and partners of Wisdom Wealth Strategies. Their shared passion is simple: to bring financial empowerment, understanding, and peace-of mind to people who wish to improve their financial future, build wealth for their families, and achieve financial independence. Click here to find out more about how you can work with the Denver Financial Advisors at Wisdom Wealth Strategies.