On average, every household in the United States has over $90,000 worth of debt. This includes mortgages, student loans, personal loans, credit cards, and other types of debt. At this point, it’s fair to say that most of the country is intimately familiar with the sinking feeling of accumulating debt. It can be overwhelming at times.
Most people in these circumstances constantly try to figure out a way to pay off their debt obligations. Debt consolidation and borrowing funds from your 401K plan are some of the potions people look into, but would you consider the latter a good solution? This retirement fund can be a great resource to help pay off a loan, but what are the risks involved? When saving up sufficient funding for retirement is a challenge for many, taking money out of such a fund is a decision you should consider very carefully.
Let’s take a closer look at the issue.
Is Borrowing From Your 401K a Good Idea?
If you have been contributing regularly for more than a couple of years to your 401K, chances are you have tens of thousands of dollars accumulated in it, if not more. Retirement assets such as this can make up a significant proportion of a person’s overall wealth profile. As such, they can be useful sources of funding that can be used to alleviate certain financial crunches, such as:
- Avoiding impending bankruptcy
- Preventing foreclosure on a home
- Providing yourself with essential daily needs during hard financial times
- Covering your medical costs when facing a life-threatening medical situation
The Pros and Cons of Dipping Into Your 401K
There is no denying that taking money out of your 401K can be a wise move, but this will depend on what use you put the money to. The potential downsides, however, are easier to point out.
For one, you will incur a potential opportunity cost whenever you take money out of your 401K. These funds are typically invested in various financial assets on the open market, and in case the assets appreciate, then you will have deprived yourself of potential earnings by taking your money out. This can be more considerable than many imagine, as you will not only miss out on the base appreciation in the value of those assets but on the compounding interest you would have been passively earning over many years. The net loss can run into hundreds of thousands of dollars.
Another potential pitfall will come if you find yourself parting from the company you work in before paying back the money you took out. Under such circumstances, the borrowed money will become instantly due, putting you in a difficult spot. You might be compelled, under such circumstances, to reclassify the loan as a distribution. In this scenario, you will be liable to pay income tax on the loan and pay a 10 percent penalty for early withdrawal.
In short, every financially prudent advisor will tell you that borrowing from your 401K inevitably places your retirement comfort at risk. On the flip side, however, you can benefit directly from taking money out of your 401K in case the financial markets experience a sharp decline. Your decreased exposure will have saved you from the potential losses.
How Much Money Can You Take Out of Your 401K?
While most retirement plans offer their members the option to take loans on their savings, this is not a mandatory requirement. You will need to make inquiries with your plan’s administrator to find out whether you have the option of taking out a loan. According to the Internal Revenue Service, in cases where such loans are facilitated, the loan limit for borrowers will be whichever one of the following is the lower figure:
- $50,000
- Either $10,000 or 50 percent of your current account balance
This means that a person with less than $50,000 in their account will have a limit of $25,000, while people with more than $100,000 in their plan cannot borrow more than $50,000.
What Are the Interest Rates on 401K Loans?
All loans have interest rates attached to their payment – that goes without saying. Even so, different types of loans can have different interest rates. In the case of loans taken from your 401K, you will still be charged interest as you make payments, but this money will be deposited right back into your 401K. In essence, you will be paying the interest to yourself since you essentially lent the money to yourself.
So, how much interest can you expect? Your plan’s administrator will determine the exact rate you’re charged. In most cases, this will be determined regarding the Prime Rates being charged on the open market. This is the rate for most financial institutions and banks.
Use to set up the various lines of credit and loans they offer to the public.
How Taking a Loan Out of Your 401K Affects Your Credit Score
One of the best features of 401K loans is that even if you default on your payments or fall behind, your credit rating will not be negatively impacted. When you apply for a loan with another institution that wants to check your credit report, any shortfalls regarding your 401K status will not show up, as 401K lenders do not submit this information to reporting agencies.
The Ramifications of Early 401K Loan Repayment
Broadly speaking, there are no rules against paying back your 401K loan before your stipulated time, but each plan provider might have different rules in place, making it prudent to make inquiries before taking such a course of action. Some plans, for instance, will only allow you to make a one-off payment if you want to clear your debt early rather than spread them out across multiple installments.
Final Thoughts
Taking loans and credit shoUld always be a carefully thought out decision, regardless of who the lending party is. Even though 401K loans might be attractive due to their relatively free availability and trouble-free terms, they should not be your first resort when it comes to paying off debt. The risk such loans pose to your retirement plan should make them an emergency option you will only take when circumstances leave you without options. Whatever your decision regarding these loans, be sure to consult your financial adviser and look up all the information you need to make the most effective and beneficial choice for yourself. Your future self will thank you.