When you’re facing debt from credit card bills, medical costs, or other sources, it can be tempting to look for any money you can access to get out of debt as fast as possible. Many workers in America have a 401(k) retirement account through their workplace. These accounts have contributions from your paycheck, and are usually matched by your employer. Moreover, because the payments to the account are deducted automatically, and because you don’t frequently access the account, most workers have a relatively large sum in their 401(k) when compared to the other funds they have access to.
However, 401(k)s are complicated accounts, and you need to understand the implications of using your retirement funds to pay off bills. While there is a way to use your 401(k) to resolve debts properly, and times when it is in your best interest to do so, you’ll want to understand the different aspects of interacting with your 401(k).
This guide will go over the consequences of borrowing from your 401(k), the limits on 401(k) borrowing, the different terms for borrowing from your 401(k), and help you understand the difference between borrowing from your 401(k) and taking an early distribution from the account. Understanding these different components of 401(k) accounts and debt will help you make the best choice for your financial future.
The Consequences of Borrowing from your 401(k)
401(k) accounts are special types of retirement accounts. They enjoy certain benefits in terms of taxes to encourage people to put money away for when they are older. However, because of the special nature of these accounts, there are more consequences to using funds from a 401(k) before you retire than there would be for using a checking or savings account, or for other financial assets like stocks.
The first consequence that you should consider when borrowing from your 401(k) is that that money won’t be in the account to help it grow. 401(k)s are invested in various mutual funds and other assets, so the more you have invested, the more money the account generates as the investments grow in value. Borrowing from your 401(k) means that money is no longer invested, and so it isn’t generating any returns for you.
Moreover, if you fail to repay your loan on time, then it counts as a disbursement. This has tremendous tax implications, as premature disbursements from a 401(k) are taxed at your current tax bracket rate plus 10%. This means if you are in a middle tax bracket of 25%, then you’ll be 35% the value of your disbursement in taxes. That can result in a substantial hit to your nest egg, and makes the money you’re accessing incredibly expensive.
Limits on 401(k) Borrowing
There are other limits on 401(k) borrowing. A 401(k) is intended as a retirement fund, so these restrictions are intended to make it inadvisable to borrow from the account unless you truly need it and have no other choice.
You can only borrow up to 50% of your vested 401(k) savings. This means that, no matter what, the whole value of the account won’t be available to you. Moreover, there is a fixed upper limit of $50,000 for borrowing from a 401(k). This means that a 401(k) doesn’t offer the same kind of flexibility you’d get from other options, like a consolidation loan, when it comes to resolving your debt.
Interest Rates on 401(k) Borrowing
One of the nice things about borrowing from your 401(k) is that you will usually get a favorable interest rate. The rates for these loans are similar to a 30-year mortgage. Therefore, borrowing from your 401(k) can be a good idea if you’re using the money to pay off debt with a much higher interest rate.
401(k) Loan Repayment
401(k) loans are usually repaid over a 5-year schedule. The loan is repaid through deductions from your paycheck. While this is convenient for those with great job security, it does create complications for the HR office, and might not be the best move if you are thinking about leaving your job or if your job lacks the necessary security.
Benefits of Borrowing from Your 401(k)
Borrowing from your 401(k) gets you access to the funds you need to pay down your debts quickly. Moreover, you don’t have to fill out any applications, because you already own the money. Repayment is straightforward, as it’s deducted from your paycheck. This makes borrowing from your 401(k) a reasonable option if you need cash fast and can’t or don’t want to apply for another kind of financial product.
However, it’s important to keep in mind the risks of borrowing from your 401(k). If you aren’t able to pay the loan back in time, then you face large tax penalties. Moreover, the money won’t be around to help your account grow. There’s a huge difference between a 4% return on $1,000 and a 4% return on $25,000, and you’ll want to protect your nest egg so you can live the life you want and deserve when you retire.
Understanding the Difference Between Borrowing and Distribution
It is possible to take money from your 401(k) early instead of taking a loan, but there are some major differences between the two acts. Taking an early distribution incurs large tax penalties, your current tax bracket plus 10%. If you withdraw $10,000 from your 401(k), and are currently taxed at 25%, then you will pay $3,500 to access the funds. That’s a very steep price to pay for money, and it isn’t worth it to do this in most circumstances.
Instead of borrowing or withdrawing from your 401(k), you should consider other debt solutions first. There’s a wide variety of options for modern consumers when it comes to financing debts, from consolidation loans to home equity loans and home equity lines of credit. All of these options offer many of the benefits for 401(k) loans, like low interest rates and ease of access, but they don’t carry the same penalties, making them a better option for most consumers today.