Saving money in a tax-advantage retirement savings account is a good practice for anyone earning an income today. It’s the chance to be able to retire in a way that is desired with enough money to make that happen. Only a few dollars from each paycheck can compound over time to become a viable retirement fund. At times, however, households may need some extra cash for an emergency. Taking a 401k loan might be a solution to that problem.
There are some pros and cons to consider before finalizing the paperwork for a 401k loan. Here are some specific points to consider.
The Pros of 401k Loans
1. There is no financial penalty when using these funds.
401k loans don’t even provide an income tax issue once the paperwork has been finalized. It isn’t considered a formal withdrawal, so there aren’t any financial penalties to the amount of money that is received. The only exception to this would be if a default would happen on the loan. Then the worst case scenario is that the outstanding portion of the loan becomes a withdrawal and taxes/penalties are paid on that amount.
2. It is a very feasible bad credit loan solution.
Credit checks don’t happen with a 401k loan because the money is guaranteed from the retirement account. This means someone with a terrible credit score can still get the funding they need for a specific need without worry of a denial.
3. It’s an easy application.
There isn’t a long application form to fill out. There aren’t numerous people you’ll need to list as references. The application takes only a few minutes and most loans are available within a few days at most.
4. You get to benefit from the loan further on in retirement.
The interest rates that you pay on your 401k loan go directly back to your retirement account. This means that your loan repayment schedule will actually benefit you in a long-term perspective.
5. Interest rates are usually lower than offered on traditional financial products.
Most 401k loans have very low interest rates. Not only are they better than most credit cards, they’re often better than most other loan products. This means if a household needed to purchase a new vehicle, for example, they could use the money from the 401k and pay less in interest than if they received the loan from a bank.
The Cons of 401k Loans
1. It reduces the investment potential of the money that has been saved.
Any gains that you’ve achieved in your 401k account are kept up until the decision to take out a loan is made. At that point, the cash needed for the loan is removed from the pool of investment cash to cover the loan in case a default occurs. This means any potential gain from that money will be removed.
2. You’ll be taxed twice on the amount of the money used to repay the loan.
Your income will be taxed before it is made available to you for spending. Once taxed, you must pay the loan amount due every month to avoid default to restore the amount. Upon withdrawal, you’ll then pay another income tax amount on each distribution you decide to take.
3. Your loan may be called on immediately.
Most 401k loans are only valid while working for the same employer. If you lose your job or need to switch jobs for some reason, then the total outstanding amount of the loan might be called. You then have the option of paying the money back into the account immediately or defaulting on it and paying the income tax and penalties on the remaining distribution amount.
4. It isn’t always allowed.
Not every 401k plan allows for loans. Even for those who are self-employed, it is necessary to check with the plan provider before planning on receiving a loan.
5. It reduces overall contribution levels until the loan gets paid off.
You might be contributing regular payments to your 401k plan, but until you pay off the entire loan, your new contributions will be going towards the loan itself and not toward building value.
There are times when a 401k loan makes a lot of sense.
For households expecting a large inheritance or have poor credit and the need to make a large item purchase, then a 401k loan can be very beneficial. If other financial resources have not yet been exhausted, however, then it may be better to evaluate other options first.
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