Watching your 401(k) account grow can give you a lot of confidence and peace of mind about the road ahead. You’ve worked hard to save that money. And maybe you’ve received some extra funds with an employer 50% contribution match too. But what about taking care of some debts in your life? Does it make sense to take money out of your 401(k)?
Getting answers to these questions can be terribly complicated. So it’s a good idea to schedule a consultation with a trusted financial advisor. Of course, it doesn’t hurt to arm yourself with a little background knowledge before making that call.
The Difference Between 401(k) Loans and Withdrawals
Many people don’t realize that you can move money out of your 401(k) in different ways. Each process has its own set of rules. For a withdrawal, the primary thing to remember is the “age restriction.” As of 2021, if you choose to withdraw funds from your account before the age of 59 ½, then you could be facing some additional taxes later on. That’s because an early withdrawal is subject to income tax. This action often will also come with a 10% penalty.
Instead, you might want to think about a 401(k) loan. If you’re hoping to free up some cash to address a financial emergency—then you certainly have the option to pull from your own retirement savings account. You’ll just want to understand the pros and cons first.
Benefits of Borrowing From Your 401(k)
Loans on your 401(k) are currently available for up to 50% of the account balance. This can be a useful strategy because you don’t need to pay taxes on the money that’s lent to you through the account. (Remember: It’s when you withdraw funds—not take a loan—that you have the income tax, and maybe even a penalty.)
The next point about borrowing the funds is that you’re intending to pay it back. This means you’ll return to your original account balance for your retirement savings.
Lastly, those loan payments you’ll be making come with interest. But borrowing from your 401(k) can be better than taking a loan out with a bank because you’ll actually be paying interest back to yourself. In a sense, that interest is still staying with you. It’s just going into another account!
Possible Disadvantages of 401(k) Loans
When it comes to money management, there’s hardly a fool-proof system. Taking a loan out with your 401(k) can also have its drawbacks. These disadvantages may not be as critical as withdrawing funds, but you still want to keep the facts in mind.
First off, although you would have the intention of repaying the loan, it still comes with an opportunity cost. Any money that you take out of the account won’t earn interest. And while your own interest payments for repaying the loan count for something, they aren’t going to be as much as what you would expect to get by leaving your 401(k) balance alone.
You should also note that if your 401(k) plan is set up with your employer, leaving your job would require you to immediately pay back the sum total of your loan amount. This could be tricky to pull off. But if you don’t, then that remaining loan balance would ultimately be facing the same income tax and early withdrawal penalty that you intended to avoid.
There are a lot of factors to consider when making your decision. Hopefully this quick overview has given you a little more background information as you figure out your next move!