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Britt Erica Tunick is an award winning financial journalist who has spent the past 17 years writing about virtually every aspect of finance. She has mastered the art of boiling down complicated financial topics for readers to understand. |
The point of putting money into your 401(k) is to make sure you do not touch it and that it continues to grow on your behalf. Should You Tap Your 401(k) for a Loan? By Britt Erica Tunick The point of putting money into your 401(k) is to make sure you don’t touch it and that it continues to grow on your behalf. But that doesn’t mean you can’t access your money if you really need to. Just know that doing so isn’t always your best bet and can have long-term repercussions. Under the terms of 401(k) programs, investors who remove money from their accounts before hitting the pre-defined 59 ½ retirement age face an instant tax on any money withdrawn, as well as an early distribution penalty tax, usually 10%. There are, however, specific exceptions that allow you to remove money from your fund without incurring penalties. The Internal Revenue Service (IRS) allows first-time home buyers to borrow money from their 401(k) holdings on a tax-free basis for a down payment. This can be an attractive option, as borrowing that money from your 401(k) essentially means taking a “loan” that is not reported to the credit bureaus and will not factor into the debt to income ratio that mortgage lenders rely on when reviewing mortgage applications and deciding mortgage rates. Make no mistake, however, taking money out of your 401(k) for a home purchase is ultimately no different than taking out a traditional loan. Money removed from your 401(k) must be re-paid, with interest, within a set time period. Failure to re-pay money borrowed from a 401(k) not only means the need to pay income taxes on the balance of what was borrowed, but the 10% early withdrawal penalty as well. It is also important to avoid borrowing from a 401(k) for a home purchase if you are considering changing jobs in the near future, or believe your job is not secure. If leaving the job tied to your 401(k) means you are no longer a participant in that company’s 401(k) plan you may be required to repay that loan in full at the time of your departure from the company. One exception to this rule is employees whose 401(k) holdings are already vested in their company’s plan and able to maintain their account even after leaving the company. But it is important to check out the specific rules regarding your individual company’s treatment of your 401(k) plan if you leave your employer. Other exceptions where the IRS allows 401(k) investors to remove money from their funds tax-free before retirement include employment termination for account holders who are 55 or older; withdrawal of an amount below what is legally allowed as a medical expense deduction; a court order requiring a division of assets as the result of a divorce; the sudden classification of the account holder as disabled or the death of the account holder. Whether you are able to remove money from your 401(k) fund early for any of the above exceptions, one of the most important things to consider is that doing so ultimately reduces the rate at which your holdings will compound and can leave you with a significantly lower balance at the time of retirement. |
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