Consider These Issues before Taking a Loan from Your 401(k)

In general, you would want to delay taking funds out of your 401(k) plan. Each individual may have different circumstances, but the general rule of thumb many financial professionals share is that while a 401(k) plan is an easy source of money, borrowing from it is not a great idea in many situations for these various reasons:

1. Interest on 401(k) loans is generally not tax deductible.
   
2. Loans usually must be repaid within five years (or earlier if you should leave the employer).
   
3. Money borrowed from the plan stops earning interest or potential investment gains and can diminish your retirement nest egg.
   
   
   
4. If you do not pay the loan as scheduled, you may be subject to added penalties and interest.
   
5. You will potentially pay taxes on the loan interest again; when you later withdraw the money for retirement, the proceeds you receive in retirement will cause you to pay ordinary income taxes, and it will include the interest amounts which you paid back to your 401(k) account on the loan.
   

The best savings strategy is to set aside money before you have a chance to spend it. A tax-deferred retirement plan, such as a 401(k) plan, can provide an excellent way to save money for retirement. Thus, taking money back out using a loan from your 401(k) plan or borrowing from it to pay back current living expenses may not solve the bigger problem, which might be the need to budget smarter and look for ways to cut your expenses or increase your income in order to obtain a current cash flow situation which will allow you to be able to save and invest money for your long-term goals such as retirement and a purchase of a home.

Assuming you are under age 55½, you would also want to avoid withdrawing the funds from your 401(k) plan to pay bills, as you would incur not only income tax on the distributions but would also be subject to the 10% early withdrawal penalty for pre–age 59½ distributions, unless an exception to the 10% penalty exists. This strategy would not only diminish your retirement nest egg but also have you pay a 10% penalty and additional income taxes on
the withdrawals in the year of withdrawal.

About the Author

Dwight Nakata, CPA, CFP, is a member of the Orange County chapter of the Financial Planning Association and the Orange County/Long Beach chapter of the California Society of Certified Public Accountants. He has an independent financial planning firm and is also currently a partner in a CPA firm in Southern California. Contact him at 714-329-5022 or email him at dwight.nakata@genworthrr.com or at cpa.nakata@earthlink.net.

Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, Certified Financial Planner^™, and the federally registered CFP (with flame logo) in the U.S., which it awards to individuals who successfully complete the CFP Board’s initial and ongoing certification requirements.

IRS Circular 230 Disclosure, pursuant to Internal Revenue Service Circular 230: Any tax advice contained in this communication does not constitute a formal opinion satisfying such requirements under IRS Circular 230. The tax advice included in this written or electronic communication was not intended or written to be used, and it cannot be used by the user/recipient of this document for the purpose of avoiding any penalties that may be imposed by any governmental taxing authority or agency.