Risks Associated with Taking Out a Loan on a 401k

22 Jan, 2016 / By

The majority of 401k plans allow people to withdraw a loan from the account, and so many people do take advantage of this. In fact, an average of 13,000 people take a loan out from their 401k every month, for a median of $4,600. Yet, about 10% of these people end up defaulting on their 401k loans, which is usually caused by a job loss or change that they did not anticipate. On top of this, there are some risks involved. Here are some of the top risks to look out for when considering taking out a 401k loan.

Borrower Limits

Those that have 401k plans can borrow up to 50% of what they have in their account, which can be as high as $50,000. This means that if you only have $10,000 in your 401k, you can only borrow $5,000. In fact, the loan amount could be even further reduced if you have already taken out a loan within the year.

Short Repayment Period

It is often the case that loans taken out of 401k account have to be repaid within 5 years. However, if you use the loan in order to purchase a house, you may extend the repayment period. This means that in most cases, you will only have a short amount of time to repay a substantial amount of money, which increases the risk of you defaulting.

Large Penalties for Missing a Payment

A loan that is not paid back with regular payments made within 5 years will be treated as being a distribution from your 401k. This will mean the entire balance of the loan you take out becomes subject to an income tax. For those who are under the age of 59 and a half, a 10% penalty will be placed on the loan balance because of the early withdrawal. One way to offset this risk is to have the money automatically taken out of your paycheck.

Leaving Employment

If you find a new job or lose your current job then you may find that the loan balance you have outstanding will become due. At this time, if you aren’t able to repay your loan then it will become distribution and penalties and taxes will typically be applied to it. This could stop you from taking an opportunity that comes your way. Or you may find yourself unemployed, and not only dealing with finding a new job but a loan that has turned into a withdrawal you owe a slew of taxes on.

Double Taxation

401k contributions are done with pretax dollars, and so the money is not taxed unless you withdraw it. However, loan repayments of both interest and principal are made after-tax. This means you will have to deal with a double taxation when it comes to the interest you have to pay, since when it comes time to retire you will have to pay taxes on the entire benefit of the plan, and a portion of which is the interest you paid for the loan you took out.

Less Money In Your Retirement Fund

Taking out a loan on your 401k ultimately will reduce the amount of money you have once you retire. Because of this, it is incredibly important that you think carefully before taking out a loan from your 401k. You should ensure that you have exhausted all of your other options. It may be a better idea to try cutting back on your spending and living within your means to avoid losing money on an account that was meant for your retirement.

Jennifer Hamilton

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