Many retirement plans, such as 401 (k) and 403 (b), allow participants to borrow money from their retirement savings. While this is your money, there are many things to consider before embarking on that retirement plan.
It’s a loan, a lot of free money
One of the most common mistakes people make is that borrowing from their 401k is the same as going to a bank and taking money from a savings account.
That couldn’t be further from the truth. When you borrow money from your 401 (k), you take out a loan. Like a car loan or a home loan, this means that you promise to pay what you borrow.
When you start a loan from your retirement plan, you will need to establish a repayment plan, which for most loans ranges from one to five years.
The loan repayment will begin shortly and will automatically be deducted from your paycheck. As if you were to take any other type of loan, it will now be a regular expense to pay.
Interest and fees
Another thing to consider before lending against your retirement fund is regarding the various fees and interest rates you will be charged. Most plans charge a one-time loan fee that can be more than USD 75, regardless of the size of the loan. This means that even if you were to borrow USD 1000, and they were charging a USD 75 fee, you would lose 7.5% from the top.
In addition to fees, you also have to pay interest as you would for any other loan. One good thing about interest is that you actually pay with interest. So you are actually putting a little more money into your account instead of the bank that received the interest. The common interest rate is the current base rate plus 1%.
If you remember, your pension plan contributions are tax-based. This means that you get a tax deduction when contributing to the plan, and then you will be taxed in the future when you take the money out of the plan. Unfortunately, when you take out a loan from your plan, you may be subject to additional taxes.
And while regular 401 (k) contributions are deducted from pre-tax payroll, the loan repayment is not. This means that you take pre-tax money from your account and then return it for a fee. This can cause some of this money to be taxed twice.
Reducing the power of mixing
Compound interest is one of the biggest assets you need in a retirement plan. Over time, the interest and profit of money in your snowball account and it can accumulate significantly.
When you withdraw money from your retirement account, you reduce the amount of money that can be reduced. As you slowly repay the loan with little additional interest, this controversial repayment plan can adversely affect the rate at which your money can grow if it stays within your 401 (k) as a whole.
The consequences of leaving the employer
As mentioned at the outset, this is a loan and has to be repaid.
If you leave the employer sponsoring the plan, you are still on the hook for the loan. In some cases, you may request a coupon book and continue to make payments, but if you fail to continue making payments or are unable to repay the loan in full, you will not make the loan.
When you have borrowed a 401 (k) loan and have not reached the age of 59, the IRS treats the loan as a distribution that would not only be subject to income tax, but also an additional 10% early withdrawal penalty. This can quickly get into your retirement savings.
Understandably, life happens, and there are times when you really need the extra money. Ideally, you will want to have an emergency fund set aside to cover those situations, but for many, turning to a retirement plan can be one of the few options.
Before moving on to a 401 (k) loan, make sure you first consider all the other options and have a full understanding of what it will cost to borrow from your retirement plan.