The economy has got you down. You are struggling to make ends meet and you worry about money constantly. Then someone reminds you that you can always start borrowing against 401k funds and you wonder if that’s the solution to all of your financial problems. Then you learn that when you pay your loan back, you actually pay yourself interest. What could be better than that?
So, you jump on your computer and you go to your 401k manager’s website. You find the loan application, fill it out and prepare to send it off. But something stops you. Suddenly, you aren’t sure whether or not you are doing the right thing. We’re we saving money into our 401k and IRA for the future? If we take that money out now, won’t it hurt us in the long run? If 401k loans are the answer, then why isn’t everyone taking them out?
These are all good questions. Let’s look at the advantages and the disadvantages of taking out a 401k loan.
Reasons to Start Borrowing Against 401k Funds:
The first thing you should know about borrowing from 401k funds is that it should only be considered if you have absolutely no other options. Taking out a personal or private loan will be more financially advantageous for you in the long run. However, if you need money immediately or you are unable to secure a loan through traditional means, your employer may allow you to borrow from your 401k. Essentially, you are making a withdrawal from your account with the intention of paying yourself back later with interest.
This is the main advantage of borrowing against 401k funds. You are basically the lender and borrower all rolled into one. You do not have to run a credit check on yourself, nor do you have to wait for a decision on the loan. If you have poor credit, this might be your only option to get the funds you need right away. You can borrow up to 50 percent of the vested value of your 401k, which means if your balance is high, you can get a very large loan without collateral, a down payment or a credit check.
In addition, your 401k loan will not be reported to credit bureaus. This is important if you are trying to improve your credit or you simply don’t want the amount of money you’ve borrowed indicated on your outstanding debts. This feature, though, does have a drawback. If this loan isn’t reported to credit bureaus it will do nothing to help you build your credit score when you pay it off. For people who do not have much credit, getting a loan and paying it back on time can really boost their credit rating. For this reason, it might be better to go with a traditional loan if that is an option for you.
Reasons to Not Borrow Against Your 401k Funds:
The first reason not to take out a 401k loan is that you might not be able to get enough funds to make a difference. For instance, if your vested balance is low, it’s not going to be worth taking out a loan if it’s not going to make a dent in your financial issue. In addition, you need to be aware that you might not have as much money in your account as you think. Employers are required to deposit your contributions into your 401k within 15 business days of receiving it. However, if your employer matches your contribution, they do not have to match it right away. Often, employers have quarterly matching schedules that might not coincide with your need for a loan.
You also need to know that your 401k loan must be repaid within five years of taking out the loan. If you do not repay it during this term, you will be required to pay a 10 percent early withdrawal penalty on the amount you borrowed. This is because you are not supposed to touch your 401k funds until you are 59 ½ years old, when you can start receiving distributions without a penalty. Moreover, when borrowing against 401k funds, you are not earning interest or investment growth during that time. This could significantly impact your retirement funds, which is why experts almost never recommend taking out a 401k loan.
Borrowing from 401k funds also has tax implications that you simply cannot ignore. You will be required to pay taxes on the loan amount because you did not pay taxes on it when it was deposited. The tax rate for 401k distributions is usually around 20 percent. This would not be so bad except that you will have to pay taxes again on the amount later. After you have paid the loan back and start taking distributions for your retirement, you will have to pay taxes on it again.
All-in-all, borrowing against 401k funds can get you out of a financial tight spot if you simply have no other options. However, before you submit your application, you really need to understand what you are getting yourself into. If the pros outweigh the minuses for you, then taking out a loan on your retirement account could be a solution to your financial problems.
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