If you have a 401(k) account, it can be very tempting to borrow from your account especially when your balance is very high and a loan could easily pay off existing debt, fund a home purchase, or pay for college tuition. Before you make the decision to borrow money, there are several things you must keep in mind to avoid risking your funds.
Borrowing from a 401(k) can seem like a risk free loan, especially since you repay yourself with interest. However, there are costs involved that are not readily apparent to the borrower who elects to take out a loan:
1. On the borrowed funds, you lose all tax-favored investment returns. In other words, you are effectively charged extra interest for the loaned funds.
2. Any interest you pay, even though you are paying yourself, is not deductible, but will be taxable to you when the plan pays you back via future distributions.
3. You may have to pay a fee to take out the loan. Add this expense to the loan costs to see if a loan is still cost effective.
4. If you leave your place of employment before paying off your loan, you will be required to pay the loan back in its entirety immediately. If you do not have the funds available to pay back the loan right away, you will then be subject to IRS taxes and penalties which can eat up as much as 30% or more of your borrowed funds depending on your tax bracket. The IRS treats all loans that are not paid back as disbursements.
Yes, a 401(k) loan can help fund life's emergencies, but the hidden costs and fees involved as well as potential taxes and penalties can quickly turn a good thing into a bad move.
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