By Chris Webb
At first, glance, taking a loan from your 401(k) plan seems easy and efficient. After all, interest rates on the amount you borrow may be low and you’re really only borrowing from yourself. Or you might consider taking an outright withdrawal, figuring that you have many years to continue saving for retirement. Either way, tapping your 401(k) plan can cost you more than you realize.
The most obvious pitfall to taking an outright withdrawal from your 401(k) plan is that it potentially reduces the amount of money you accumulate for retirement. Most experts agree that contributing a little of your pre-tax earnings regularly into a 401(k) can help you accumulate more than if you put off contributing until a later date when you might contribute more to make up the difference. Even though your lifetime contributions may be the same, the person contributing the earliest would potentially earn more through the years. That’s because time and compounding combine to potentially grow your dollars.
Another disadvantage to taking an outright withdrawal is that you incur income taxes, no matter how old you are. Because your 401(k) contributions are made pre-tax, the full amount of your distribution would be taxable in the year it is taken. If for example, you take $10,000 from your 401(k) to buy a car or remodel your home and 30% of your distribution goes toward state and federal taxes, you really only have $7,000 left after taxes and that’s if you are age 59 1/2 years old or older.
If you are younger than that age, you will most likely be subject to an additional 10% federal tax penalty on any money that you take outright from you 401(k). Add it all up, the income taxes, penalty tax and potential compounding that you’ll miss and you can see that the costs of an outright withdrawal are high.
Taking a loan
Some 401(k) plans allow plan participants to take out loans against their account balance. Essentially you borrow from yourself of up to 50% of their account balance, up to a maximum of $50,000, whichever is less. By taking a loan, you potentially accumulate less over your lifetime than if you hadn’t taken the loan, making the loan payments each month can also add stress to your monthly budget. If you change jobs and your plan requires full payment of the loan before you leave, you risk defaulting on the loan and subject yourself to immediate taxes and penalties on the amount if you can’t pay the loan in full. Employed and unemployed, loans except those used to buy a primary residence, must be paid back within five years.V