A 401(k) is a retirement benefit account implemented under the sub-section 401(k) of the Internal Revenue Code of the United States. The employers establish the 401(k) on behalf of their eligible employees who may contribute by deferring certain amount from their salary on pre or post tax basis. Employers may also contribute either on matching or on non-elective basis. Although the idea behind establishing the 401(k) is to provide the employees with a retirement benefit, analysts point out a recent surge in the amount of borrowings made from the same. While there are genuine reasons to borrow against the 401(k), there are more valid reasons for not to borrow money from the retirement benefit accounts. This article shall describe some of these reasons for the benefit of those who are contemplating borrowing from the 401(k) without exhausting the other methods.
Could end up with a considerably low retirement benefit
When a person borrows from his or her 401(k), there is a possibility that the plan would not allow the person to contribute further until the borrowed amount is completely repaid. This would mean that the person puts on hold the present 401(k) balance for the duration of the loan without making any further contributions or gaining any interest for the borrowed amount. In numeric terms, a person contributing $500 per month to the 401(k) would actually miss out on $18,000 if it takes 3 years to repay the loan. When considering that a person’s 401(k) usually doubles every 8 years, this could mean a substantial loss on interest amounts as well.
Changing jobs could be costly
Following obtaining a loan from 401(k), a borrower who decides to take over another job should repay the debt within 60 days of quitting the previous job. At the same time, if the person is below the age of 59½ years, he or she has to pay a penalty of 10 percent from the borrowed amount as early withdrawal penalty while the amount borrowed would be added to the taxable income. In addition, a 10% tax would also be imposed on the borrowings.
Inability to pay would mean further losses
In instances where the person is unable to repay a 401(k) loan, the aftermath would be similar to that of early retirement. Thus, if inadequate finances made the person default on his or her loan payments, having additional taxes and penalties would further worsen the persons existing financial status.
Exhaustion of an emergency funding source
401(k) is a great way to maintain an emergency fund, which can be used to obtain emergency relief. However, a borrowing from the 401(k) for a reason other than for an emergency would make it non-available for such needs. Thus, one should make sure that before thinking about the 401(k), he or she has exhausted the other avenues of obtaining funds while the reason for borrowing from 401(k) is worth the risk of losing a ‘safety cushion’.
When looking at these reasons, it is apparent that 401(k) should not be used as a readily accessible funding source for even the important life events, which can be funded through other means. Thus, a person should think twice before deciding to borrow from 401(k) given the long-term disadvantages of such borrowings as against the short-term benefits.