You may be considering a 401k loan if you are in need of quick access to capital, as for many people retirement accounts are their largest source of funds. Many 401k plans allow you to take out a loan of up to 50% of the funds you have contributed after your account has reached a preset limit.
Taking out a loan against your 401k may seem like a good ides due to the lack of a credit check, low interest rates, and a maximum five year payback period. There are not many banks or financial institutions that would give you as good of a deal.
There are some potential drawbacks to borrowing from your 401k account which could be expensive. While there are legitimate reasons not to borrow from your 401k, there has been widespread concern about 401k double taxation.
401k Double Taxation
Financial experts have been cautioning investors that taking out a 401k loan is a bad idea due to idea that you will be subjected to double taxation on your funds. The theory is that you contribute to a 401k plan with funds that have not been taxed yet. Then, when you repay yourself the loan, you will have to do it with money that has already been taxed.
Consequently, when the money is withdrawn in retirement, it is taxed again. Meaning that you have lost a considerable amount of money to 401k double taxation. While this theory has been widely promoted, it doesn’t hold water, as the only thing subject to being double taxed is the interest that is required to be paid, which is minimal.
It may seem logical that the funds are double taxed, although if you examine it further the theory falls apart. In reality, any loan that you repay is paid with after-tax funds. While this is simple enough to understand, the confusion is with the first pre-tax contribution to your 401k.
As the first contribution was made with pre-tax funds, you will repay it with with after-tax money. You are technically paying taxes for funds that you already owe, however, you are not paying taxes twice. Everything essentially equals out by repaying your pre-tax funds with those that are after-tax.
401k Double Taxation: Drawbacks To Borrowing From Your 401k
You then pay the one time tax on a typical withdrawal. While there may be may valid reasons not to take out a loan against your 401k, 401k double taxation is not one of those reasons.
There are other real concerns including harsh penalties for not repaying the loan, a possible inability to contribute to the fund while the loan is outstanding, and a reduction in your take home pay. These factors must be carefully considered before borrowing from your 401k plan.
If you loose or leave your job for any reason prior to the loan being repaid, you will have only 60 days to repay the funds or the loan will be treated as an early withdrawal, and subject to 10% early withdrawal penalty. The withdrawal will also need to be reported as taxable income.
There are also 401k plans that stipulate that you can not contribute additional funds to your 401k until the initial loan is repaid. You will not only miss out on the opportunity to increase your savings for retirement, but you could also miss out on the matching contributions from your employer.
You also have the added drawback of a reduction in your take home pay, as 401k loans are repaid through payroll deductions.
The rules concerning borrowing from your 401k plan can seem overwhelming, and not abiding by them can be costly. Ask the retirement account experts at ETrade, or a trained financial adviser to find out what options are right for you.
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