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If you are considering taking a loan from your retirement plan to bridge a financial gap, pause for a minute. This is a major decision that should not be made lightly, as there are consequences that could affect your ability to fund your future retirement. Here are six things you need to be aware of before you borrow from your 401(k) savings:
1. You’ll incur double taxation:
You will repay the loan with after-tax dollars, and because the interest you pay is not tax-deductible, you will pay tax on it again in the future when you retire and start withdrawing funds from your account.
2. Your take-home pay will be reduced:
Most plans require you to start repaying the loan (via paycheck deductions) almost immediately after you borrow the money. Your loan payment will reduce your take-home pay, potentially affecting your ability to meet your monthly expenses.
3. Your taxable income may increase:
In order to stay on track for retirement, you’ll need to pay your loan and keep making 401(k) contributions. Otherwise, if you reduce or eliminate your normal 401(k) contributions, your taxable income may increase. Your loan repayments are not tax-deferred, and they do not reduce your taxable income like 401(k) contributions do. As a result, you could shift into a higher tax bracket until you repay the loan and begin to contribute to your retirement savings again.
4. Your repayment schedule will accelerate if you leave your company:
If you lose your job or leave the company, it’s not uncommon for plans to require full repayment of a loan within 60 days. This could create additional unforeseen financial stress on your household.
5. Failure to repay by the deadline will trigger a taxable event:
Most 401(k) plan loans must be repaid within five years. If you do not repay your loan based on the terms of the loan agreement, your employer will treat the loan balance as a distribution, triggering income taxes and the 10-percent early withdrawal penalty if you are younger than 59½.
6. You’ll incur double taxation (on interest only):
While there is a little “myth” around being double-taxed on your loan, you do incur paying tax twice on a small portion of your repayment. Since you will repay the loan interest with after-tax dollars and it is not tax-deductible, you will pay tax on that interest again in the future when you retire and start withdrawing funds from your account.
Example: Emma has a balance in her 401(k) account of $20,000. Emma defers $300 per month (or $3,600 annually) of her pre-tax salary. Her employer matches 50% of her deferrals or $150 per month. Emma decides to take a loan of $10,000 from her 401(k) account. The terms of the loan are $10,000 with a 6% interest rate and a repayment duration of 60 months. Because Emma’s loan repayments will come out of her paycheck and reduce her take-home pay, she decides to stop contributing to her 401(k) plan until the loan is paid off. In other words, she stops contributing $300 per month. This also means she doesn’t receive the $150 that her employer is matching. As a result, Emma has removed $10,000 from her account. In addition, she is no longer contributing $5,400 each year for 5 years ($3,600 in deferrals and $1,800 in match). Assuming those assets, if they had remained invested in her account, earned a 7% rate of return, the value of Emma’s 401(k) account in 30 years would have been $711,316.90. Because they were not, her account value is only $521,921.18 and her lost opportunity is $189,395.72.
Your 401(k) plan is one of the best ways to save for retirement and help ensure your future security. Explore alternative options and consider all the implications before you take a loan or withdrawal from your employer-sponsored retirement plan. Otherwise, you may regret today’s decision when you need this money most—at retirement.