Here are six reasons a 401(k) loan is often a bad idea.
You end up putting your contributions on hold
All this eventually will put your tax-deferred retirement savings on hold. Borrowing money from one's 401k account can significantly reduce the amount of wealth one could have otherwise generated.
Not all employers permit loans from their plan. There's a limit on how much you can borrow. You may lose investment gains from the money you withdrew. You might feel tethered to your employer for longer than you want.
A loan lets you borrow money from your retirement savings and pay it back to yourself over time, with interest—the loan payments and interest go back into your account. A withdrawal permanently removes money from your retirement savings for your immediate use, but you'll have to pay extra taxes and possible penalties.
Borrowing From Your 401k Doesn't Count Against Your DTI
Even though the 401k loan is a new monthly obligation, lenders don't count that obligation against you when analyzing your debt-to-income ratio. The lender does not consider the payment the same way as it would a car payment or student loan payment.
Once you have reached retirement age, you may begin to withdraw funds from your 401(k) without incurring any penalties. At this point, your employer or fund manager cannot refuse to give you the money in your fund, either as a lump sum distribution or as equal periodic payments.
Receiving a loan from your 401(k) is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your credit rating. Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress.
If you can't repay the loan, it is considered defaulted, and you will be taxed on the outstanding balance, including an early withdrawal penalty if you are not at least age 59 ½. ... You have no flexibility in changing the payment terms of your loan.
If you've taken out a loan against your 401(k) savings account and lose your job, it could generate an unexpected tax bill. And that borrowed money could morph into a taxable distribution that comes with an early withdrawal penalty. ...
The IRS allows penalty-free withdrawals from retirement accounts after age 59 ½ and requires withdrawals after age 72 (these are called Required Minimum Distributions, or RMDs). There are some exceptions to these rules for 401ks and other qualified plans. Try to think of your retirement savings accounts like a pension.
Hardship distributions
A hardship distribution is a withdrawal from a participant's elective deferral account made because of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need. The money is taxed to the participant and is not paid back to the borrower's account.
A 401(k) loan should be used as a last resort; you likely have better options. ... It's a relatively low-interest loan option that some people use to consolidate credit card debt — meaning, taking a more favorable loan to pay off several high-interest credit card balances.
401(k) loans are not reported on your federal tax return unless you default on your loan, at which point it will become a “distribution” and be subject to the rules of early withdrawal. Distributions taken from your 401(k) before age 59 1/2 are taxed as ordinary income and subject to a 10% penalty for early withdrawal.
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