When you need money for emergencies and you have depleted your other resources, you might be thinking about taking a loan out against your 401k retirement account; that would not be your best idea.
Retirement plans were originally established by the federal government as a way to help individuals save for retirement on a tax favored basis. Therefore retirement accounts such as IRA’s and 401k’s are meant for retirement only and when used for any other purpose the federal government taxes these retirement accounts.
A good financial planner will always tell you to use your retirement accounts as the very, very, very last resource when you need emergency cash. If deciding between a 401k loan or a 401k withdrawal, choose a loan if that option is available. A 401k loan is better but only if you pay the loan back.
How To Use Your Retirement Accounts
401k Retirement Account Loans
- You will have to pay back a 401k loan if you want to avoid paying 401k taxes.
- The IRS considers an unpaid 401k loan a distribution.
- If you are under age 59 1/2 that distribution is considered an early distribution.
- If you are under age 59 1/2 that early distribution would be subject to a 10% penalty plus federal income taxes.
401k Retirement Account Withdrawals
You will be taxed on a 401k withdrawal if you are under age 59 1/2.
- You cannot pay back a 401k withdrawal to avoid taxes; once you make the withdrawal that’s it.
- Even though 401k withdrawals are allowed by law, don’t forget that the purpose of a 401k retirement account is to invest and save for your future, your retirement.
- 401k withdrawals will hinder your efforts to prepare for a secure retirement.
- 401k withdrawals can defeat the purpose of why you are investing.
Listen To Your Financial Planner
- It is in your best interest to follow your financial planners advice.
- Your financial planner is correct when they tell you to always use other sources of funds for emergency cash first before tapping into your 401k retirement account. Use your 401k retirement account as a last resort.
- Other sources of funds will generally not be subject to tax penalties and federal income taxes like your 401k withdrawals and unpaid 401k loans will be.
- If your employer matches your 401k contributions, one benefit you lose when you make a 401k withdrawal or take out a 401k loan is that matching, even if you pay back your loan. Employer matching is free money so you never want to hinder that benefit.
- You also lose the benefit of compounding. When you take out a loan or make a withdrawal your account balance shrinks therefore the magic of compounding works on a smaller amount.