In the event of a financial emergency, how would you come up with the necessary cash for living expenses, medical bills, or a home repair? Asking yourself this question ahead of time, before a crisis ever emerges, is always a good idea. When we’re under pressure, it can be much easier to make big mistakes with money.
Often, those facing a large, unexpected expense are tempted to take a loan from their 401k account. It looks like a good idea on the surface; you’re borrowing from yourself, rather than a bank, and the interest rate is often comparatively reasonable (usually the prime rate, plus 1 to 2 percent*..
So, what’s the catch? Why does most financial advice warn against 401k loans?
Taxes. First, you will confront a problem with income taxes. If you take a distribution from your retirement account (in this case, a loan) before age 59 ½, you must strictly adhere to the repayment schedule. If you miss even one payment, the loan is now counted as a taxable distribution. You will owe income taxes on the amount withdrawn, at your normal percentage rate, along with a 10 percent penalty fee for the early withdrawal. Ouch!
The cost of missed opportunity. As unfortunate as taxes and fees might be, the cost of missed opportunity can be even greater. As long as the money you’ve borrowed is missing from your retirement account, you will be missing out on the compounding interest it could have earned. And, you can’t get that time back once it’s gone!
If you’re considering a 401k loan, taking the time to identify other ways to cover an emergency expense can save you a lot of trouble and money down the road. Even better, make a plan for life’s little surprises now, so that you never have to scramble for a solution under duress. For more information on financial planning and retirement solutions, give us a call. We can help you investigate your options.