Many people get loans for different reasons. They either want to buy a house or a car, or they need to consolidate debt. Banks are usually the best and only source for most individuals who need the extra money. Anyone who has bought a house has had to deal with a bank to acquire such a mortgage loan.
Borrowing money from a 401(k) should always be the last resort. This means that if it's possible to get a loan from some other source (i.e. bank), then that is usually the best course of action. After all, money is put aside in a retirement account so that money will be there when the individual retires.
Disadvantages of a 401(k) Backed Loan
Why should a 401(k) be the last source for loans? One of the main reasons is that there is a maximum amount of time the loan must be paid back, unless it is to buy a main home. So no matter how much is borrowed, the investor has a maximum of five years to pay it back. This repayment must also be deducted from the person's paychecks for the remainder of the loan.
Up to 50% of the vested (wholly owned by the investor) balance can be borrowed. Let's say that the account has $100,000 in it. Then $50,000 can be borrowed. If this is to buy a car or pay off other debt, it must be paid back within five years. What happens should the borrower lose his job after a year into the loan? He has two options, and neither of them is good.
First, he either has to pay back the remaining amount, which would be more than $40,000. Since it's doubtful he would have that amount of money available, he would need to borrow it from another financial institution. This would most likely increase the interest rate with the new loan, if one can be acquired.
Significant Tax Consequences for Early Distributions
Second, he can default that amount and pay taxes on it as income. Not only that, but he might also have to pay an additional 10% early withdrawal penalty. So if he is in the 15% tax bracket, he could owe a minimum of $6,000 on his federal income taxes. That doesn't even include the addional penalty, which could push the total taxes above $10,000.
Another disadvantage of borrowing against a retirement account is that while that money is out of the account, it's not earning dividends or appreciation on those funds. Since that is the point of having a 401(k) account, it sort of makes it ridiculous to get such a loan.
Minor Advantages of a 401(k) Loan
All these negatives do not mean there aren't advantages as well. Some people might have poor credit which makes it either impossible to get a loan or they must settle for an inflated interest rate. Getting a loan backed by a retirement account usually earns the investor a much lower interest rate, making the loan repayments much more affordable.
In case of emergency, a 401(k) loan might be the only and/or fastest way of getting much needed cash. In a situation like this the positives might outweigh the negatives, but it is always in the best interests of the investor to get that loan paid back as soon as possible.
Source:
- 401(k) Distributions on IRS website
Judith Lee - Judith has been a writer for over two decades. She is also a blogger and book/movie reviewer.
