If you are trying to bridge a financial gap and considering taking a loan from your retirement plan, pause for a minute. This is a major decision that should not be made lightly, as there are consequences that could affect your ability to fund your future retirement. Below are six things you need to be aware of before you borrow from your 401(k) savings:
You’ll incur double taxation. You will repay the loan with after-tax dollars, and because the interest you pay is not tax-deductible, you will pay tax on it again in the future when you retire and start withdrawing funds from your account.
Your take-home pay will be reduced. Most plans require you to start repaying the loan (via paycheck deductions) almost immediately after you borrow the money. Your loan payment will reduce your take-home pay, potentially impacting your ability to meet your monthly expenses.
Your taxable income may increase. Most likely, you will reduce or eliminate your normal 401(k) contributions until you have repaid the loan. Your loan repayments are not tax-deferred, and they do not reduce your taxable income like 401(k) contributions do. As a result, you could shift into a higher tax bracket until you repay the loan and begin to contribute to your retirement savings again.
Your repayment schedule will accelerate if you leave your company. If you lose your job or leave the company, it’s not uncommon for plans to require full repayment of a loan within 60 days. This could create additional unforeseen financial stress for your household.
Failure to repay by the deadline will trigger a taxable event. Most 401(k) plan loans must be repaid within five years. If you do not repay your loan based on the terms of the loan agreement, your employer will treat the loan balance as a distribution, triggering income taxes and the 10-percent early withdrawal penalty if you are younger than age 59½.
You will lose the magic of compounding. There is an opportunity cost associated with long-term compounding earnings. When you take a loan from your 401(k), you lose the ability to earn interest on that money, which can affect your total portfolio balance come retirement.
Your 401(k) plan is one of the best ways to save for retirement and help ensure your future security. Explore alternative options and consider all the implications before you take a loan or withdrawal from your employer-sponsored retirement plan. Otherwise, you may regret today’s decision when you need this money most—at retirement.
Illustration: How 401(k) Loans Can Affect Retirement Savings
Authored by Brad McMillan, Senior vice president, chief investment officer at Commonwealth Financial Network.
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