What do we need to know right now about 401(k) loans?
We have seen a significant rise in 401(k) loans in recent years. Loans against retirement accounts have been taking the place of home equity loans because fewer Americans have home equity in the wake of the housing market collapse in 2008. But these loans are risky, and they have the potential to cost people cash and significant potential earnings, and can cause a lot of grief in the process.
Is this a common practice?
It actually is. Out of all Americans who participate in 401(k) plans that allow account holders to take loans out against their retirement savings, around 1 in 5 do so, according to the Employee Benefit Research Institute. This is a signal that many Americans are putting their future financial security at risk in order to live beyond their means in the present.
Why is taking a 401(k) loan such a risky money move?
There are a few reasons that taking a loan against your retirement is a bad idea. First, you are unlikely to be able to add to your account while you have a loan out against it. Most 401(k) plans have rules that bar contributions to the account as long as there is an outstanding loan balance.
So, your 401(k) will miss out on any contributions you would have made for as long as you have not paid off the entire loan, which can take months and even years. On top of this, you are missing out on the growth potential of these contributions. As Investopedia notes, “because the whole point of having a 401(k) plan is to use it is as a way to save for the future, you are defeating the purpose of having this account if you use it before you retire.”
But isn’t the fact that it is your money helpful? That way you aren’t owing the bank at least, right?
Here is the thing though, if you get to a point where you cannot pay off the loan, there are big financial consequences for that in the form of taxes. If you take out a 401(k) loan, you are normally required to pay it off within five years and make payments every quarter.
If you don’t do both of those things, the entire unpaid amount of the loan is subject to income taxes, and – if you are under 59 and a half – a 10% penalty for early withdrawal. All told, you could end up paying over 40% of the total amount withdrawn in taxes and fees. So, while may people tell you that these loans allow you to lend to yourself and pay yourself back, they don’t mention that you may be shorting yourself and benefiting uncle sam.
A 401(k) plan is employer sponsored. Does that play a part in these loans?
Yes. You are required to pay your loan back – typically within 60 days –if you leave your job and move to a new one. And I am not talking about continuing quarterly payments. You have to pay back the entire outstanding balance. And if you do not, you are back to the situation we were just discussing: taxes. In the event that you do not repay your loan, your former employer will alert the IRS and the IRS will hit you with taxes and penalties. This is where things get serious. If you do not have the money to pay back your loan, and the accompanying taxes, you are now in trouble with the Internal Revenue Service.
So, taking out a loan against your 401(k) can also cause you to be stuck in your job until you pay that loan back, it can mean you get stuck having to come up with the cash to pay the entire balance back in a short period, or it can cause the IRS to cast its sights on you. None of these are great options. Remember, your 401(k) is your future. If you protect it and contribute to it, it will pay you back in spades in the future.
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