Losing Money In Your 401K Through Borrowing
A majority of the population does not need any of these 401k options for their retirement. That said, some people are convinced that these things are not tax traps and that somehow everything will work out OK.
If you are the type of person who is convinced that their 401k plan is doing good things for you (and will continue to do so), you might as well get the most out of it. You can do that by just leaving it alone. Don't loan money out of it. Don't even think about borrowing from it for any reason.
The reason for this is that if you cash out your 401K, you will pay taxes, and a penalty, and that won't be fun, but it's a one time hit. When you take a loan against your 401K, that's the penalty that keeps on giving. First, you give up the earning potential of the money inside the plan, because these "so called" loans are actually a withdrawal of funds out of the plan (on a tax-free basis).
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.
Loaning money to yourself is basically replacing the interest you get from one source with another. That's unfortunate in some respects because the money is not in your account. While this may be good during a market downturn, it essentially represents a higher savings rate with 0% return from investments.
Unfortunately, the consequence of withdrawing funds from your 401k plan as a "loan" means that the interest you pay is after-tax. The more loans you make, the more money will be subject to double taxation later when you withdraw the money during retirement.
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 are the type of person who is convinced that their 401k plan is doing good things for you (and will continue to do so), you might as well get the most out of it. You can do that by just leaving it alone. Don't loan money out of it. Don't even think about borrowing from it for any reason.
The reason for this is that if you cash out your 401K, you will pay taxes, and a penalty, and that won't be fun, but it's a one time hit. When you take a loan against your 401K, that's the penalty that keeps on giving. First, you give up the earning potential of the money inside the plan, because these "so called" loans are actually a withdrawal of funds out of the plan (on a tax-free basis).
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.
Loaning money to yourself is basically replacing the interest you get from one source with another. That's unfortunate in some respects because the money is not in your account. While this may be good during a market downturn, it essentially represents a higher savings rate with 0% return from investments.
Unfortunately, the consequence of withdrawing funds from your 401k plan as a "loan" means that the interest you pay is after-tax. The more loans you make, the more money will be subject to double taxation later when you withdraw the money during retirement.
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.
About the Author:
David C Lewis, RFA, offers advice on personal finance. If you want more information about any aspect of personal finance, please visit David's website.
posted by Debt Consolidation Loan at
3:56 AM
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