401(k) Loans | business loan against 401k |quick small business loans | law fundix

Understanding the Risks of 401(k) Loans

It may sound deceptively easy to take a loan out on your 401(k), but that really doesn't mean there aren't huge downsides in place that could get you in boiling hot water. Basically, it could get ugly. We'll break that down here with a deep look into why taking a 401(k) loan is a really bad idea.

The Risk of 401(k) Loans | quick small business loans

Borrowing from your 401(k) might seem to be a quick fix if things are a little tight moneywise, but it's not free of its potential downsides. A gimme with the process of borrowing, here are the few important downsides: It is a pretty easy way to get into big trouble. A more nuanced look at why you might want to think twice about dipping into retirement money follows here:

    

401(k) Loans | business loan against 401k | law fundix

1. Tax Inefficiency

Tax inefficiency is one of the significant disadvantages of 401(k) loans.

Interest is being subject to double taxation: When one repays a 401(k) loan, one is using money that has already been taxed. That cannot be said about a mortgage payment, on which one will, generally, get a tax deduction on the interest paid. It's different with a 401(k); the interest you pay actually pays another person interest with money that has already been taxed. You get to pay tax on it again when you draw it upon retirement.

Cost Comparison: Most will find that the double taxation makes it still seem like not that enormous a big deal when compared to the high interest rates for consumer loans. However, borrowing a significant amount and, especially, paying it back over many years, the costs can add up.

2. Repayment Risks Upon Exit from the Labor

A 401(k) loan has rather harsh perils in case one leaves employment before the whole amount that was being lent out as a loan is repaid back.

Immediate Return: If one retires from service for any reason, he or she would most likely have to return the full amount of loan in a very short period of time. If that is not doable for any reason at all, then it turns into a dividend, fully taxable.

Tax Triggers: And if that's not supposed to be bad enough, an additional 10% early-withdrawal penalty applies in addition to income tax if a person is under 59½. That's like double pain to your pocket.

Risk of Inadvertent Withdrawals: In the event that you retire or no longer work for an employer, you may have probably been counting on rolling over your 401(k) as part of the taxable distribution. If your loan is outstanding, you will receive the same tax reporting treatment and you could potentially create an unwanted tax bill at year-end. This, of course, is not really in the spirit of why retirement accounts were set up in the first place only to have that pile until those retirement years.

3. Long-Term Impact on Retirement Savings

A 401(k) loan has repercussions far from today.

Missed Opportunity for Growth: The money you borrow is that which otherwise could have been invested in the market while you are paying off the loan. Yes, you shall lose potential market gains that may actually impact seriously the results of your retirement savings.

Extended Loan Repayment: When availing of the 401(k) loan for house purchase, you can possibly take an extended amortization repayment period. The longer the time frame is generally, then less time the money will be inside the loan, thereby compounding in your retirement account.

4. 401(k) Loans vs. Withdrawals

While you're borrowing from your 401(k), you also need to be thinking about—sooner or later—when you don't have much choice, paying back into your 401(k). Both options are beset with disadvantages and are less than ideal.

Loans: Essentially, you're loaning money to yourself and then paying that money back to the plan, with interest. If you leave your employer and have a loan outstanding, you'll have to pay the loan back in full, or the plan will consider that you have taken a distribution—a form of early withdrawal—and you'll be taxed with all the relevant taxes and penalties.

Withdrawals: You may think that is an easy way out since you won't have to pay the amount taken back. However, you do owe taxes, and maybe even penalties, on the amount withdrawn. Further, a withdrawal reduces retirement money permanently, and that could be a big loss for you over the long run.

Wise Decision

While borrowing from your 401(k) shouldn't be the first choice when you need cash, it can be a viable option if you are extremely careful. The rule of thumb here is: You can only borrow for what you can pay back comfortably within the time limits, and you must understand full well any tax characteristics and risks involved in an investment. Have a solid plan to pay it back, and consider other options before dipping into retirement assets.

Get more insight into the management of your retirement finances to make informed decisions.