3 Risks of 401k Borrowing

401k borrowing is a process that allows you to take out a loan on the value of your 401k account. With this type of loan, you will be borrowing against the cash value of your retirement assets. Once you borrow the money, you will have a certain amount of time to pay it back, with interest. One of the primary reasons that people use this type of loan is because it does not count as an early distribution of retirement funds and the money is not taxable. Even though 401k loans are popular, there are a few drawback and risks of borrowing.

1. Early Distribution

When you borrow money from your 401k, there is a risk that you may not be able to repay the loan. If you do not repay the loan according to the terms that were set forth, the IRS will consider the money that you borrowed an early 401k distribution. When this occurs, you have to pay a 10 percent early distribution penalty as if you had simply taken the money out of your account.

In addition, you will also have to count the money as regular income. You will have to pay income taxes on the money that you borrowed. This could potentially significantly increase your taxable income for the year and put you in a higher tax bracket which will increase the percentage that you have to pay taxes at. This can be a very costly mistake to make.

2. Opportunity Cost

When you borrow money from your 401k, you typically plan on paying it back at a particular rate of interest. In most cases, the interest is nominal because you do not want to have to make too big of payments to the account. When you do this, you are missing out on opportunities to invest in other securities in your account. In order to invest in stocks and bonds through your 401k, you have to have money in the account to do so. This means that you will miss out on the opportunity to make even better returns with the money that you borrowed. 

3. Ruin Retirement

Some people who borrow money from their 401k end up squandering the money on something that is not important. Then they do not have the money to pay back the loan. As mentioned earlier, you will be hit with an early distribution penalty and you will have to pay taxes on the money. Beyond that, you could potentially ruin your chances at retirement.

The money from your 401k is what you will most likely be living on once you hit retirement. If you waste all of this money on something you will not have it there when you are ready to retire. Building up a 401k account typically take many years and a lot of hard work. If you take out a loan, you can set yourself back so that you have to start the process all over again. If you are relatively young, this may not be a big issue for you. However, if you are close to retirement, it could be potentially devastating as you might have to keep working forever. 

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