Stay In Or Cash Out, But Don't Loan Against Your 401K
Almost nobody needs an individual 401k. That said, some people are convinced that these things are not tax traps and that somehow everything will work out OK.
If you just can't bring yourself to ditch your 401k, that's OK. You can get something out of it by just leaving it alone. Don't go borrowing money from it. Even if you qualify for the so-called "hardship" provisions, leave it be.
First, when you take a loan from a 401k, it's not really a loan, per se. You are withdrawing funds from the plan. Since they aren't in the plan, they are not invested. The investments had to be liquidated so that you could have the money.
Bonds represent a fixed investment. The amount of the return is known in advance. You are lending either a corporation or the U.S. Government money in return for interest plus the return of your principal.
When you loan yourself money in a 401(k) though, you are simply replacing the interest you would already be receiving with interest payments from yourself. Remember, you have taken out money from your 401(k), and since it is not in your account while it's on loan, you are not earning interest in the stock, bond, or money market. You've simply substituted one borrower for another or changed the source of interest.
In addition, the interest payments you make back to your 401(k) are with after-tax dollars; and consequently, when you make a final distribution on that money, you will pay tax again on the money you paid back as interest.
Every time you take a loan from your 401k plan, you repeat the process of building up funds that will be taxed twice. This is incredibly unfortunate and necessary. The gimmick of the plan (the tax savings) can then become nullified through even moderate borrowing throughout your lifetime. This is on top of the regularly required taxes on distribution.
If you just can't bring yourself to ditch your 401k, that's OK. You can get something out of it by just leaving it alone. Don't go borrowing money from it. Even if you qualify for the so-called "hardship" provisions, leave it be.
First, when you take a loan from a 401k, it's not really a loan, per se. You are withdrawing funds from the plan. Since they aren't in the plan, they are not invested. The investments had to be liquidated so that you could have the money.
Bonds represent a fixed investment. The amount of the return is known in advance. You are lending either a corporation or the U.S. Government money in return for interest plus the return of your principal.
When you loan yourself money in a 401(k) though, you are simply replacing the interest you would already be receiving with interest payments from yourself. Remember, you have taken out money from your 401(k), and since it is not in your account while it's on loan, you are not earning interest in the stock, bond, or money market. You've simply substituted one borrower for another or changed the source of interest.
In addition, the interest payments you make back to your 401(k) are with after-tax dollars; and consequently, when you make a final distribution on that money, you will pay tax again on the money you paid back as interest.
Every time you take a loan from your 401k plan, you repeat the process of building up funds that will be taxed twice. This is incredibly unfortunate and necessary. The gimmick of the plan (the tax savings) can then become nullified through even moderate borrowing throughout your lifetime. This is on top of the regularly required taxes on distribution.
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Author: Only so much information can be covered in one article. If you would like more detailed information about any aspect of personal financial planning, please visit David's website.
posted by Credit Counseling at
7:42 AM
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