By: John J. Kasperek, President
It is a part of life that people may find themselves in a bind and need quick access to cash. The good news is that most 401(k) plans have a loan provision. The bad news is taking a loan against your 401(k) can have dire consequences if you are not careful.
Borrowing from your retirement nest egg should never be taken lightly!
Advantages of a 401(k) Loan
- Few roadblocks. Normally there are no credit checks or mountains of paperwork to fill out.
- Attractive interest terms. Rates are typically low. With a 401(k) loan, you are also paying yourself the interest since the interest is put back into your 401(k) rather than a bank.
Disadvantages of a 401(k) Loan
- High Fees. Loan origination fees & annual maintenance fees are not unusual.For example, a $1,000 loan over three years could cost $75 in origination fees AND $25 annual maintenance fee. That’s $150 in fees, or 15%. Ouch!
- Lost Investment Growth. You are forgoing all the potential tax-deferred growth that you otherwise would be earning: One, the borrowed money will not be invested for the entire time the loan is outstanding. Two, the 401(k) plan may prohibit your contributions while you have an outstanding loan. If your employer matches contributions, you’d lose out on that, too.
Either way, think about the magic of compound interest-in reverse. Ouch!
- Risk From Job Loss. If you’re laid off or terminated, your 401(k) plan might require that you pay back the loan within 30 or 90 days. If you do not , then you default…
- Dangers Of Default. If you do default, you will be subject to a massive federal and state tax liability. Maybe over 40%. Ouch!
(Don’t forget you can default from any inability to pay, including the circumstance that led to the loan in the first place).
A 401(k) loan is certainly an option. It is without question better than a flat-out withdrawal, which will come with the massive federal and state tax liability, without escape, described earlier.
This is just a simple overview of a 401(k) loan. Please speak to us as an unbiased advisor at length about all the consequences and look at other alternatives, before making a final decision.