The Two Biggest Traps Behind 401(k) Loans and How to Avoid Them

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The old pension funds would very seldom allow loans why then should the 401(k)? This is your future. Avoid loans at all cost.

Hazard #1 – Steep taxes and penalties that come from late payments or switching jobsIf you don’t make a payment on your 401(k) loan for 90 days, the outstanding amount of the loan is treated as a distribution. That means it loses its tax-deferred status and Uncle Sam will require the taxes paid on the outstanding amount plus penalties.  Specifically, the IRS taxes the outstanding balance at your current tax rate, and if not of retirement age (59 ½), you will owe an additional ten percent penalty.  If you took a loan, finding the money to cover this penalty is insult to injury – not to mention hard to pay off.

There are several equally hazardous scenarios that have the same brutal outcome on your pocketbook. If you decide to quit or are let go from your job, the outstanding 401(k) loan amount is due quickly — typically within 60 days. If you don’t pay it back in this time period, it is considered a distribution and will be taxed at your current tax rate plus a ten percent penalty.  Not pretty.

Hazard #2 – A big dent in your retirement savings

While borrowing from a 401(k) provides an easy and low-cost path to immediate cash, the impact on your retirement savings can be dramatic. Time is the key to building a healthy nest egg.   It’s why 20-year-olds who start by contributing small amounts in a 401(k) are often much better off than those in their 40s that contribute a much greater amount to their accounts. This effect is called compounding.  The time your money is out of your 401(k) from the loan is time it will never have again to work for you and grow through compounding.  Additionally, the tax advantages you were enjoying by contributing to your 401(k) vanish.

This is why it’s so important to exhaust every other means to manage your cash needs such as bank loans, a home equity line, etc. before turning to your 401(k).

Loans from your 401(k) must be your last resort. This is another case of protecting your future self from your current self.

Please comment or call to discuss.

  • Raiding Your 401(k) Can Be Taxing (turbotax.intuit.com)
  • 401(k) Nation: Road To Retirement Gets Rockier (401kplanadvisors.com)
  • How to Manage Your 401(k) Through Market Down Swings (401kplanadvisors.com)
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