If your credit card balance becomes too high or you need a large down payment for a home, the money in your retirement account can look like the perfect solution to your problem. But before jumping in, it’s a good idea to consider the whole picture. The pluses of withdrawing the money are obvious: you get your credit card paid off or you can get the home you want. But what are the negatives to taking money from your 401(k)?
One major drawback is that many plans contain provisions that prohibit you and your employer from making new contributions to your plan until you repay the loan or for up to 12 months after you take out the loan. This means that you cannot save for retirement during the time you are repaying the loan (which may take years) or at least for the year in which contributions are prohibited.
The effects of suspended contributions and the lost earnings and tax-free compounding that you could have earned on the money you borrowed can add up to far more than expected. Often a 401(k) loan has an interest rate of one to two percentage points above the prime interest rate. This may seem better than paying a higher interest rate to a bank for a loan, but you are also forfeiting the potential earnings that money could be making if left in the plan.
Another point to consider is that if your loan does not meet specific requirements, it could be treated as a premature distribution for tax purposes. Some of these requirements are that the loan must be repaid within five years (with the exception of a loan for a first-time home purchase), repayments must be made at least every quarter, and if you leave or lose your job you must repay the loan within 60 days. If these requirements are not met, the IRS treats the outstanding loan balance as a premature distribution, incurring a 10% penalty and taxed as regular income.
This brings up the third point to consider: potential double taxation. The interest you pay on the loan is money taken from your paycheck after taxes. This means that the money you pay yourself interest with is taxed in your paycheck currently, then again later with it is distributed to you from the plan in retirement as ordinary income.
How much can you borrow?
So how much can you borrow from your 401(k)? In general, you are limited to 50 percent of the value of your vested benefit or $50,000, whichever is less, although you may take a loan up to $10,000 even if it is more than one-half of the present value of your vested accrued benefit. The interest you pay on the loan is not deductible, but you will remain vested in your account.
These are a few reasons to consider other alternatives before borrowing from your 401(k). Please contact us if you have any questions about this topic.
written by Pat Pettersen, Audit Supervisor