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If you’re like many people, you work for a company that offers a 401(k) plan to help its employees save for retirement. First seen in 1978, 401(k) plans became more popular as companies moved away from offering their employees pensions, mainly due to the expense. As they’ve gained popularity over time, the financial myths about 401(k)s have increased as well.
The Basics of a 401(k)
A 401(k), which gets its name from the IRS code Section of the same name, defers taxes on income that’s put into a retirement investment account. While the investment is voluntary, many companies will match any contributions made by the employee up to a certain percentage of his or her salary. Thus, not taking advantage of a 401(k) is akin to throwing away free money. Additionally, the investments are made through payroll, so it doesn’t feel like you’re handing over a chunk of your money with each paycheck. The IRS does put a cap on the amount you can invest into your 401(k) each year at $19,000.
You’re responsible for paying taxes on your contributions; they’re tax-deferred, not tax-free. You’ll pay taxes on the money when you retire and begin receiving disbursements, so you’ll most likely be in a lower tax bracket than in your high-earning years.
The money is yours and is invested with whatever amount of risk makes sense for you: a higher risk when you’re young and lower risk as you near retirement, typically.
Despite it being your money, there are hefty penalties for withdrawing before you reach the age of 59½. If you do, you’re responsible for income tax on the money as well as a 10% early withdrawal penalty.
However, you can borrow money that you’ve invested in the plan, and many people use this as a way to avoid putting a large purchase on a credit card or going to a traditional bank for a high-interest loan. Because the repayments are usually taken out by payroll, much like your contributions are, it’s easy to avoid missing payments.
There are pros and cons associated with borrowing from your 401(k), and many people are confused by them.
Learn four of the biggest financial myths about 401(k)s.
Myth #1: You’ll Never Come Out Ahead if You Borrow from Your 401(k)
If you have high-interest credit card debt that you want to pay off with your 401(k), you’ll save money. Interest rates on 401(k) loans are low; typically, 4% and that interest you pay goes into your 401(k), so you’re paying the interest to yourself instead of to a bank or credit card company.
Of course, it’s important to run the numbers to see how much your interest rates are and how much you’d actually save. In some cases, you may not be allowed to continue to contribute to your 401(k) while you have an outstanding loan. If this is the case with your company, you shouldn’t borrow from your 401(k).
Myth #2: You’ll Be Required to Pay Taxes on the Loan Amount Twice
Many people still believe this is the case even though it’s been debunked throughout the years. The confusion is that you put pre-tax dollars into your 401(k) but then repay it with your after-tax dollars. The only part of the money that’s “taxed twice” is the interest dollars.
Myth #3: If You Have a 401(k) Loan and Lose Your Job, You Could Lose Your House
It’s true that if you take out a loan on your 401(k) and then lose or leave your job, you have to pay the entire loan back. You do have 60 days to pay it back. That may be enough time, depending upon the amount that you have left to pay, but if it’s not and you don’t come up with a way to pay it back, the unpaid balance will be subject to the 10% withdrawal penalty and applicable income taxes. You shouldn’t have to sell your house to pay for those.
Still, if you’re considering borrowing from your 401(k), you should factor in your job stability and be certain that you won’t be changing jobs anytime soon.
Myth #4: There’s Never a Good Reason to Borrow from Your 401(k)
If you’re considering borrowing from your 401(k), it’s something that should be explored carefully. It’s not a pile of cash to borrow on a whim, but many good reasons exist to do it, such as paying off high-interest debt, putting a down payment on a house, or financing an education. It should never be borrowed from to pay for things such as vacations or Christmas presents, and it shouldn’t be used as an emergency fund. Even with a good reason to borrow from your 401(k), calculate the numbers to be sure.
One thing to keep in mind: whatever amount of money you borrow from your 401(k) won’t be there to earn you more money until after it’s paid back.
Now that the financial myths about 401(k)s are debunked, it’s time to start asking new questions. Borrowing money from your 401(k) can be a helpful resource, but before you do it, speak with your company’s HR or payroll representative so you understand all the terms of the loan.