Drawbacks of a 401K Loan

Retirement & Investing
on January 22, 2013

Those who are thinking about taking an early withdrawal from their 401k should think twice about that decision. There are many pitfalls and disadvantages for the majority of folks who decide to raid their retirement fund to cover their current bills.

A 10 Percent Penalty Must Be Paid

Funds withdrawn from a traditional IRA are subject to income taxes because the money is tax-deferred until it is withdrawn. However, if you take the money out before age 59 1/2, you are going to be hit with a 10 percent penalty. This means that if you take out $10,000, you will have to pay a $1,000 penalty.

You Are Losing Compound Interest

More importantly, you are taking out money that could be accruing interest for you. If you have $100,000 in your retirement account, that money will be making an average of 10 percent a year. That means you will make almost $10,000 tax-free. However, if you only have $50,000 after an early withdrawal, you will only gain half that amount each year. That money really adds up over the course of two or three decades.

There Are Exceptions To The Rules

There are a few ways that you can take out money from a 401k without taking the penalty. Some common exceptions are made for:

  • -Medical Expenses
  • -Higher Education Expenses
  • -Paying For Your First Home

The catch is that you must generally have your IRA account open for at least five years before you can take advantage of these exceptions. If your account has been open for less than five years, you still are hit with penalties and other fees.

There are better ways to pay your unexpected expenses than drawing money out of a 401k. It is rarely acceptable to sacrifice your future to take care of an emergency today. It may be easier to ask your friends or relatives for a loan or ask the bank for a loan. You have worked hard for your money, don’t throw your money and future away because you think an early withdrawal from your 401k is an easy way out.

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