401(k) loans can be beneficial, but carry big risks

Published September 5, 2018

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I’m planning a holiday vacation for myself and my family, but the price tag is high and I’m considering looking to my 401(k) account to cover all or a part of the expense. What do I need to be aware of if I choose to go this route?

It’s hard to believe that we need to start thinking about the holidays and gift giving, but we do applaud those who begin planning for these expenditures well ahead of time. Whatever you are considering this season, if you’ve pondered dipping into your 401(k) account for the money, make sure you are aware of the consequences before you take out the loan. This can be a risky option.

Pros and cons
Many 401(k) plans allow participants to borrow as much as 50% of their vested account balances, up to $50,000. These loans can be attractive for a few reasons. They are easy to obtain, with no income or credit score requirement and there’s minimal paperwork involved. The interest rates are low, and you ultimately will pay interest back right into your 401(k) account, rather than to a bank.

Yet, despite their appeal, 401(k) loans present significant risks. You may have to reduce or eliminate 401(k) contributions during the loan term, either because you can’t afford to contribute or because your plan prohibits contributions while a loan is outstanding. Either way, you lose any future earnings and employer matches you would have enjoyed on those contributions.

Loans, unless used for a personal residence, must be repaid within five years. Generally, the loan terms must include level amortization, which consists of principal and interest, and payments must be made no less frequently than quarterly.

Additionally, if you are laid off or change jobs, you will have to pay the outstanding balance quickly – typically within 30 to 90 days. Otherwise, the amount you owe will be treated as a distribution subject to income taxes and, if you’re under age 59 and a half, a 10% early withdrawal penalty.

Hardship withdrawals
While the demands of holiday shopping and travel aspirations do not qualify, if you need the money for emergency purposes, rather than recreational ones, your plan may offer a hardship withdrawal option. Some plans allow these to pay certain expenses related to medical care, college, funerals and home ownership – such as first-time home purchase costs and expenses necessary to avoid eviction or mortgage foreclosure.

Even if your plan allows such withdrawals, you may have to show that you’ve exhausted all other resources. Also, the amounts you withdraw will be subject to income taxes and, except for certain medical expenses or if you’re over age 59 and a half, a 10% early withdrawal penalty, which can be significant to these account balances.

Like plan loans, hardship withdrawals are costly. In addition to owing taxes and possibly penalties, you lose future tax-deferred earnings on the withdrawn amounts. But, unlike a loan, hardship withdrawals need not be paid back, and you won’t risk any unpleasant tax surprises should you lose your job.

Decision time
Generally, you should borrow or take hardship withdrawals from a 401(k) only in emergencies or when no other financing options exist (and your job is secure). For help deciding whether such a loan would be right for you, please consult a tax or wealth management professional, who should be able to help you evaluate whether it’s the right choice for you.

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