Many people find their 401(k) accounts have become one of their largest financial assets after years of regular contributions with an employer match. Some employers even allow plan participants to borrow against the funds, and that can be tempting.
Wouldn’t almost everyone like extra cash? However, a 401(k) loan can set back your retirement and create a financial bind if you leave your employer. As a result, a 401(k) loan should be considered for emergencies only, if at all.
With a 401(k) loan, you can borrow up to 50 percent of the vested balance in your 401(k) account or $50,000, whichever is lesser. However, you will have to pay the money back with interest. The interest is credited to your 401(k) account, not to your employer, so you are paying the money to yourself. Because you pay yourself, the 401(k) loan may be a cheaper way to borrow money.
Just because a 401(k) loan could be a cheap way to borrow money doesn’t mean that it’s a good idea. A 401(k) loan has several drawbacks. First, the money has to be repaid, usually over a five-year period. If you leave the company or the 401(k) plan is terminated, the loan will typically become due within 60 days. That can happen if you quit or are laid off or if the company merges with another company or goes out of business. These unforeseen events cause their own financial emergencies and set back your retirement.
If the loan is not repaid when due, then the balance will be treated as a withdrawal, and it will generally be subject to income tax on the distribution as well as a 10 percent penalty tax if you are younger than 59½. If you face a serious financial emergency, then borrowing money from your 401(k) plan may make sense. It can be easy to obtain, and you pay the interest to yourself rather than to a bank. However, consider it only after you’ve exhausted your cash savings accounts. It is best to leave your 401(k) alone so that you can continue building toward your retirement goals for the future.
Information provided by Eric Schepers, State Farm Insurance, 516 Nile Kinnick Drive S., Suite A, 993-3482.