Principal Retirement: 401K Loans And Their Impact

Principal offers retirement savings plans, including 401(k) plans, to help individuals set aside money to replace their working income in retirement. These plans are designed to be long-term savings options, but in certain circumstances, individuals may be able to take out a loan or request a withdrawal from their 401(k) plan. While this can be a convenient way to access cash for short-term financial needs, there are important considerations, such as the potential impact on future earnings and the risk of penalties and taxes associated with early withdrawal.

Pros and cons of 401k loans

Retirement savings plans, such as 401(k)s, are designed to be a long-term savings option to help replace income when you retire. While it is possible to take a loan from your 401(k) plan, there are several pros and cons to consider.

Pros of 401(k) Loans

• You don't have to pay taxes and penalties when you take out a 401(k) loan, unlike with a 401(k) withdrawal.
• The interest you pay on the loan goes back into your retirement plan account.
• If you miss a payment or default on your loan from a 401(k), it won't impact your credit score because defaulted loans are not reported to credit bureaus.

Cons of 401(k) Loans

• If you leave your job, you might have to repay your loan in full very quickly.
• If you can't repay the loan, it's considered defaulted, and you'll owe both taxes and a 10% penalty on the outstanding balance if you're under 59 and a half years old.
• You'll lose out on investing the money you borrow, potentially missing out on the growth and compounding of your earnings.
• You may need to get consent from your spouse or domestic partner to take a loan.
• Your payments are made with after-tax dollars, unlike contributions, which are often made before taxes.

How to apply for a 401k loan

Principal offers 401(k) and 403(b) retirement plans. These plans are designed to be long-term savings options to help replace your income when you retire. While it is not recommended, you can take a loan from your 401(k) account.

• Understand the trade-offs: Borrowing from your 401(k) account may seem tempting, but it is important to understand the potential downsides. You may pay more than the loan amount in the long run, including taxes, fees, and penalties. Additionally, you may miss out on potential growth and compounding of your earnings.
• Check your eligibility: Log in to your online account to see if you are eligible for a 401(k) loan and understand the requirements, guidelines, and restrictions. Some plans may have a lower limit, and you may need to meet IRS requirements.
• Determine the loan amount: Calculate how much you can borrow based on your account balance. Typically, you can leverage up to 50% of your vested account balance or $50,000, whichever is less.
• Choose the loan type: Decide whether you want a personal loan or a residential loan. Personal loans typically have a term of up to five years, while the term for a residential loan may vary depending on your plan.
• Select payment terms: Choose the payment term that works best for you and how often you receive paychecks. Review the payment terms carefully to understand the repayment schedule and any associated fees.
• Provide banking details: If you choose to receive the loan amount through electronic transfer, you will need to provide your banking details. You will also be asked to provide a backup delivery method, such as standard or overnight mail, in case the online transfer fails.
• Upload supporting documentation: If you are applying for a residential loan, you may need to upload additional documentation as specified by the platform.
• Review and submit: Carefully review all the information you have provided for accuracy. Check the box to acknowledge the terms, conditions, and fees, and then submit your application.

Processing a 401(k) loan application typically takes 7-10 business days, with additional time required for fund transfers or delivery of checks by mail. Remember that a 401(k) loan should be considered carefully, as it may impact your long-term savings and retirement goals.

Interest rates and fees

When you take out a 401(k) loan, you are essentially borrowing from your own retirement savings. As you make loan repayments back into your 401(k) account, you will repay the amount borrowed plus interest. This interest is often referred to as "paying yourself" interest, and it helps your retirement account stay on track. However, it's important to note that you are paying this interest out of pocket, which can reduce your personal savings.

The interest rate on a 401(k) loan may be lower than borrowing from a bank or other consumer loans, such as credit card balances. This can make 401(k) loans a convenient and cost-effective option for short-term liquidity needs. However, it's important to consider the opportunity cost, as you will miss out on the potential growth and compounding of your earnings during the life of the loan.

Additionally, there are tax implications associated with 401(k) loans. While there are no taxes or penalties on the loan itself, the loan repayments are made with after-tax dollars, resulting in double taxation. This means your 401(k) loan repayments are subject to income tax, and when you withdraw during retirement, you will be taxed again. If you default on the loan, you will also need to pay income tax on the remaining balance, and the money cannot be returned to your retirement plan.

It's worth noting that 401(k) loans do not have the same bankruptcy protection as other debts. In the event of bankruptcy, some debts can be discharged, but 401(k) loans cannot. Therefore, it is crucial to carefully consider your ability to repay the loan before borrowing from your retirement savings.

In summary, while 401(k) loans may offer convenient access to funds and potentially lower interest rates compared to other loan options, there are interest costs, taxes, and fees associated with these loans. Borrowers should weigh the benefits against the potential impact on their retirement savings and explore alternative loan options before making a decision.

Impact on retirement savings

Retirement savings plans are designed to be a long-term savings option to help replace working income in retirement. A 401(k) is one such example of a retirement savings plan that might be offered through your workplace, where you contribute a percentage of your paycheck, typically before taxes.

While it is possible to take a loan from your 401(k) account, it is important to carefully consider the potential impacts of doing so. Firstly, the money taken from the account will no longer be invested, which means you could miss out on potential earnings and the benefits of compound interest. For example, \$20,000 in a 401(k) account could triple in 20 years at an average 7% rate of return, but not if you withdraw it early. Additionally, if you leave your job or retire, the loan will become due and payable in full, or it will be considered a taxable event, with taxes and fees applying.

The impact of short-term loans on your retirement progress will depend on the current market environment. In strong up markets, the impact is likely to be modestly negative, while in sideways or down markets, it can be neutral or even positive. It is worth noting that 401(k) loans are considered tax-inefficient as they must be repaid with after-tax dollars, resulting in double taxation. However, the cost of double taxation on loan interest is usually fairly small compared to alternative short-term liquidity options.

Furthermore, research has shown that employees who frequently take loans from their retirement plans tend to save less and have lower average plan account balances than those who do not. Multiple small loans from retirement savings are associated with lower retirement plan contributions and can hinder successful retirement outcomes. This pattern can develop due to a lack of emergency savings, causing individuals to rely on retirement savings to cover unexpected expenses. Therefore, it is recommended to maintain an emergency fund that could cover three to six months' worth of expenses to avoid sacrificing retirement security.

Taxes and penalties

Retirement savings plans, such as 401(k)s, are designed to be a long-term savings option to help replace your working income when you retire. Contributing to a retirement savings plan is your choice, but it is a great way to save for your future.

When you take out a loan from your 401(k), 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 401(k) account. However, the money taken will no longer be invested, which means you could lose out on potential earnings.

With a 401(k) loan, you don't have to pay taxes and penalties when you take out the loan. However, if you leave your job, you may have to repay the loan in full in a very short time frame. If you can't repay the loan for any reason, it's considered defaulted, and you'll owe both taxes and a 10% penalty on the outstanding balance if you're under 59 and a half years old.

A withdrawal from your 401(k) permanently removes money from your retirement savings for your immediate use, but you'll have to pay extra taxes and possible penalties. A 10% early withdrawal penalty applies to withdrawals before the age of 59 and a half, unless you meet one of the IRS exceptions. For example, the IRS considers immediate and heavy financial need for hardship withdrawal, including medical expenses, funeral expenses, and costs related to the purchase and repair of a primary residence.

Frequently asked questions