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Reasons Why You Should Avoid Borrowing From Your 401(k)


Reasons Why You Should Avoid Borrowing From Your 401kYou’re in need of money for a car repair or maybe a new car. You don’t have enough money in the bank to help and your various sources of credit are not enough. The last thing you want is to have another loan to deal with. That’s when you realize that you have all the money you need in your 401(k) account.

It may be tempting to finance that repair or purchase with your retirement fund, but there are serious downsides to doing so. Here are some reasons why you should not withdraw money from your 401(k) account and instead look for another source of funds:

Why Some People Think Borrowing From Your 401(k) is a Good Idea

When you borrow money from your 401(k), you agree to repay the amount borrowed plus a small amount of interest. Supporters of this tactic for making a large purchase compare this to getting a loan for a below standard interest rate. There are a number of good reasons not to take this route, however. For most people, the following issues outweigh this benefit.

Your Retirement Fund Stops Increasing

With many 401(k) plans, you must agree to stop making contributions into the fund until you have repaid the loan to yourself. The small amount of interest you are paying yourself won’t equal what you would’ve contributed normally. If the reason that you borrowed money from the fund is because of a hardship that you couldn’t fund normally, you likely won’t be able to contribute to the fund while you are paying off the loan. This means that your 401(k) sits idle until you pay off the loan and start contributing to it again.

You’re Making Less Investment Income

The growth of your 401(k) account is due more to how the money is being invested and less about the contributions that you make to it. Once you pull money out of the fund as a loan, there is less in the fund to invest. Since you probably aren’t making contributions to the fund while repaying the loan, you’re missing out on that money earning an investment income. Your 401(k) account now grows much slower with less money in it and no contributions being made.

You also miss out on the long-term investment income from having the money in your 401(k) for several years before you retire. If it takes you several years to pay back the loan, you stand to lose a significant amount of investment income. You could seriously impact your retirement portfolio by taking a loan out against your 401(k) and paying the loan off slowly.

Financial Problems Could Be a Serious Blow to Your Retirement

You decide to take a loan out on your 401(k) to buy that car. Suddenly, you lose your job. You tread water for a couple of months, then finally get to the point where you can’t make payments into your 401 (k) account to pay off the loan. How bad could that be? After all, you are paying yourself back, so you could be easy on yourself, right?

The problem is that once you miss making payments to yourself, the loan becomes a lump sum withdrawal. Now you will be expected to pay taxes on that money, plus a ten percent penalty for early withdrawal of the money from the fund. If you’re past retirement age, the penalties may not be quite as stiff. But if you default on a loan to yourself, your 401(k) fund is still short the balance of the loan and is making less for you.

Changing Jobs With an Outstanding 401(k) Loan Causes More Problems

Many 401 (k) plans state that you must pay off the balance of the loan should you leave the company or be terminated from your job. This may keep you from finding a better position elsewhere and advancing your career. If you do leave your job before the loan is paid off and you decide to not pay off the balance, the balance then becomes a withdrawal. You’ll now have to pay the penalty and the taxes on the loan balance.

You Lose an Emergency Source of Funds

There may be a legitimate reason for taking out a loan on your 401(k). For example, a medical emergency may require expensive surgery and follow-up care to fully recover. Your health insurance may not be good enough and you’re left looking for funds to finance your health care. If you’ve taken money out of the 401(k) for such things as a car purchase or to fund a vacation, the money may not be there for the emergency.

When There is No Other Option

Once you’ve weighed all of the downsides to taking out a loan, if you decide to proceed anyway, make sure you commit to having that money back in the account as soon as possible.

Make all of the payments on time and don’t miss any payments, otherwise you risk the loan being considered an early withdrawal by the IRS.

Pay extra, if you can, to get the balance back up to where it was as soon as possible. Every day that you go without paying off the loan, is a day where you are making less on your investments.

Make sure you fully understand all of the problems with taking money out of your 401(k) as a loan before you touch your retirement fund. The money you take out now may mean less in your account when you’re ready to stop working and enjoy your retirement years.

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