The Seven Deadly Sins of Taking a Loan on Your 401(k)
Published on August 1, 2014
Yes, it’s your money. Yes, you can look at it. But beware of taking a loan from your 401(k). While many 401(k) plans allow participants to borrow from their funds, these loans are subject to limits, fees and, yes, penalties.
According to the University of Pennsylvania’s Pension Research Council, about 13,000 401(k) participants take a loan each month. The median loan amount is $4,600 and about 10 percent of these borrowers default on these loans.
The not-so-hidden cost of taking a loan on your 401(k):
- Limits on the amount you can borrow. Participants in 401(k) plans are eligible to borrow up to 50 percent of their vested account balance (up to $50,000 if the plan permits loans).
- Typical repayment time is five years. There are certain stipulations and regular loan repayments that must be made at least quarterly over the period of the loan. For instance, if the loan is used to purchase a home, the repayment period may be able to be extended. And, repayments may be suspended if the borrower is engaged in military service.
- Miss a payment, pay a penalty. If the loan is not repaid in regular payments within five years, it is treated as a plan distribution. The penalties can be high with the entire outstanding balance of the loan subject to income tax. And, for workers under age 59½, there is a 10 percent early withdrawal penalty applied to the loan balance.
- Switching jobs. The outstanding loan balance may become due. If you are unable to repay the loan, the loan becomes a plan distribution and taxes and penalties may be applied to it. (See #3.)
- Compounding loss. You lose out on the power of compounding interest, which is one of the greatest things going for a retirement plan. By taking a loan on your 401(k), you are reducing the money that can be compounded on.
- Loan expenses. There are often origination, administration and maintenance fees as well as the interest you must pay to repay the loan.
- Double taxation. 401(k) contributions are usually made with pretax monies, which are not taxed until you withdraw it from the account. In this case, by taking a loan on your 401(k), you will be taxed twice—the loan repayments of both principal and interest are made with after-tax dollars.
Bottom line: Taking a loan on your 401(k) ultimately adds up to less retirement savings. It hurts your retirement investment growth rate and reduces the amount of money you will have at retirement.
Want to do something devilishly smart instead? Consider rolling over a former employer 401(k) into a self-directed retirement plan to help your bottom line grow.
Add to Your Bottom Line
Financially savvy investors know that retirement investment is something that must be done over time for savings to add up to sinfully strong retirement savings. And, for those who understand alternative investment options, a self-directed IRA can be a great way to build retirement wealth more aggressively. With a self-directed retirement plan, informed investors have the ability to develop a diversified portfolio that they control, with both traditional and nontraditional assets they know and understand. Alternative assets allowed include real estate, mortgages, unsecured loans, private hedge funds, precious metals, limited partnerships, commercial paper and more.
A self-directed IRA administrator like Next Generation Trust Services handles all the details of the transactions and manages all the paperwork and filing. Contact Next Generation at (888) 857-8058 or Info@NextGenerationTrust.com to learn how to roll over your former employer 401(k) to a new self-directed retirement plan. Our professionals will answer your questions about self-direction and our transaction specialists ensure you are investing within IRS guidelines. Since we do not give investment advice, we strongly recommend you consult your trusted financial advisors about your investments and any tax implications they have for your unique situation.
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