Things to consider before taking a loan from your 401k

Before you take a loan from your 401k, consider this….

 

Why did you contribute to your 401k in the first place?

 

To save for retirement. 

This is an admirable goal – one that your future self will thank you for.  Many 401k plans do not allow you to make contributions while you have an outstanding loan.  This means that you may also be missing out on employer matching contributions – which means you could be turning down free money!

 

For the tax-deferred growth. 

When you take a loan from your 401k you aren’t taking a loan from the institution with your 401k as collateral.  You are literally taking the funds out of your 401k and then paying them back over time.  That means that you would be losing the potential tax-deferred growth on those funds while the loan is outstanding.

 

For the tax deduction or tax management. 

If you contributed to your 401k on a pre-tax basis, common with a traditional 401k, then you did not pay taxes on those funds when you contributed them.  When you withdraw the funds in retirement you will pay taxes on the original contribution and any growth that has occurred in the account but you don’t pay taxes annually on the growth (hopefully) occurring in the account. 

When you take a loan from your 401k, you take out the pre-tax funds you contributed, and then you pay those funds back with after-tax funds.  And then, in retirement, you pay taxes on all of the funds you withdraw, including those repaid loan dollars.

 

Another major consideration should be what happens if you separate from your employer with a loan outstanding against your 401k.  The 401k plan document itself sets forth the options for repaying the loan at that point.  In some cases, you’ll be able to continue paying off the loan in regular installments.  However, in other cases the loan may be considered a distribution immediately.

 

There is also the difference between the plan’s treatment of the loan vs. the tax treatment to consider.  If your plan forces the distribution treatment of the outstanding loan balance at termination, the IRS allows you to “pay it back” into a rollover IRA prior to the due date of your tax return without penalty.  However, this still means that you need to have the cash to put into the rollover IRA.

 

Another thing to consider is that, even if you are able to continue payments on an outstanding loan when you separate from your employer, that option is only available as long as you keep the 401k with the current plan.  If you choose to rollover the 401k to an IRA or to another plan, the outstanding loan amount will be considered a distribution.

 

Yes, there are times when a 401k loan makes sense or may be the only option.  However, I suggest that the 401k loan be considered in emergency cases or as a last resort. 

 

It is true that you’re paying yourself interest.  But you’re paying interest with after-tax dollars whereas, if you left those dollars in the 401k, they could be earning tax-deferred returns on your investment.  And, while the interest rate on a 401k loan may be low, that means you could likely have made a better return on those funds by keeping them invested.

 

Also, keep in mind, the employer does not have to approve a 401k loan.  So, you should not simply assume that the option is always available to you.  They don’t do a credit check, but they may use other factors in their decision such as the reason for the loan, your history taking loans from the 401k, or, if you’re near retirement or the end of a contract, they may question the ability to pay back the loan since regular deductions from your paycheck won’t happen after separation from the company.

 

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

Benefits of multiple income streams

Having multiple income streams is helpful for several reasons:

 

Diversification of income:

When you rely on a single income stream, you are putting all your eggs in one basket. If that income source is disrupted for any reason, such as a job loss, a market downturn, or a recession, you could be left without any means of support. By having multiple income streams, you spread out your risk and decrease your dependence on any one source of income.

 

Increased earning potential:

By having multiple income streams, you have the potential to earn more money than you would with just one income source. This is especially true if you can create passive income streams that continue to generate income even when you’re not actively working.

 

Flexibility and independence:

Having multiple income streams gives you more flexibility and control over your financial life. You can choose which income streams to focus on and how much time and energy to devote to each one. This can give you greater independence and a sense of control over your financial future.

 

Protection against unexpected expenses:

Multiple income streams can also provide a buffer against unexpected expenses or emergencies. If one income source is disrupted or reduced, you can rely on other income streams to help cover your expenses and maintain your standard of living.

Overall, having multiple income streams can help you achieve greater financial stability, independence, and security, and it can also provide a pathway to higher earnings and greater wealth over time.

Considerations for higher interest rates

Now that the Federal Reserve raised interest rates seven times in 2022, there are some factors that you should consider in your financial planning.  When it comes to interest, it makes a difference whether you are a borrower or a lender.  We’ll talk about the factors as a lender, or saver, in today’s post.  Stay tuned for our next post on considerations as a borrower.

 

After a decade of extremely low interest rates, we finally have interest rates that can help savers.  Here are a few areas where some adjustments to your plan may be in order.

 

Is your money working for you?

Did you know that, as of February 2023, you can get 3.75% APY on your savings account at a large national bank and even higher if you go with some regional banks?  That means you can earn $375 on $10,000 of your emergency fund just by having it in one of these accounts.  On the other hand, many of the large national banks are still only paying .01% on their savings and money market account.  So, you can earn .01% or you can earn 375 times that amount by looking around for better interest rates.

 

Reconsider your accelerated mortgage payments

Have you been making additional principal payments on your mortgage to pay it off more quickly?  If your mortgage interest rate is at 3.25% and you are earning 3.75% on your funds in the bank, you may want to take the extra funds that you’ve been dedicating to mortgage payments and earn more on those funds in the bank.

 

How about your tax return?

For at least a decade, interest rates were close to zero.  Aside from avoiding giving your hard-earned money to the government any sooner than you needed to, there was little reason to ensure that you weren’t withholding too much from your paycheck in income taxes – unless you were actually investing.  Now that we have reasonable interest rates, you could be earning interest on those dollars.  The government doesn’t pay you interest on those dollars unless they unnecessarily delay your tax refund after you’ve filed your tax return.  So, now it has become a question of whether you earn interest on those dollars or the government earns interest on your dollars.  The caveat here is that you would need to put those extra dollars where you’ll actually earn the interest income rather than spending the extra dollars.

 

Note on on blog posts and newsletters:  When we work together, we examine your particular financial picture and your particular goals.  Blog posts and newsletter articles are not individualized advice.  They are intended to be thought-provoking and to surface discussion topics for your financial planning.  If you have questions about your financial plan, feel free to schedule a meeting.  Your first meeting is complimentary.

Complete the FAFSA – Even if you won’t get aid

Every year people ask if they should complete the FAFSA (Free Application for Federal Student Aid) if they know they won’t qualify for financial aid.  The answer is Yes!

In general, completing the FAFSA isn’t difficult or time consuming.  You might find that the toughest part is coordinating a time with your student to get it done.

4 Reasons to complete the FAFSA when you don’t think you’ll qualify for aid:

 

Establish a baseline

First, complete the FAFSA so you establish a baseline.  While no one wants to think about it, bad things happen to good people.  Anything from losing a job, to an illness or death in family can strike a family and drastically change their financial circumstances.  If you need to go back to a school and ask for reconsideration due to a change in circumstances, it helps to have a baseline.

Keep your options open

The FAFSA is also the application for federal direct student loans.  While subsidized federal loans are need-based, unsubsidized loans are not based on need.  Federal student loans are also not based on credit history, they have a fixed rate, repayment is deferred until 6 months after the student leaves full-time student status and there are some protections available on federal student loans that aren’t usually available on private loans.  Completing the FAFSA gives the option but not the obligation to take a federal student loan.

Might be required for merit awards

Some schools will not consider a student for any financial awards – even merit awards – without the FAFSA.

You could be surprised

Submitting the FAFSA results in the calculation of an Expected Family Contribution.  Even with significant assets, some families will qualify for financial aid depending on the school, the size of the family and other factors.

 

What’s next for you?

So, your son or daughter has finished up their applications.  You have the list of schools divided up into top choices, middle choices and safety schools.  You’re making plans for the holidays and soon you’ll be making plans for graduation. 

Looking back, you’ve attended countless games, recitals and performances and scheduled around practices and rehearsals for years.  You’ve helped them study, driven to innumerable places, and navigated so many moody nights and thorny social issues.  And soon, they’re off to college.

So, let me ask you this – what’s next for you?

For most parents, their children become their purpose.  Your focus is almost solely on raising compassionate, well-adjusted, contributing members of society.  And, if you’re staring at the college process right now, there’s a good chance that you’ve done a good job at doing what you set out to do.  But, if you’re going through the college process right now, life is soon going to be different than it has been for the last 18 or so years.  This is why I ask, what’s next for you?

Life does not end when you send your kids off to school.  It’s simply time to move on to the next stage in your life – just like the kids are doing.  That’s not to say you won’t worry and that they won’t call home when they have something to celebrate or they’re encountering new life lessons.  But they’re also finding new freedom and you can do the same.

Try this – and if you do this all the way – it can be a challenge.

Picture a vacation where you spend an entire week doing just what you love to do.  Not with the kids and don’t put any financial constraints on it – just you doing what you love to do. Think about doing what you love without stopping to drive someone somewhere, or to attend a game or a conference or an open house.  And without being required to go to work at your current job.  What would that look like?  What would you be doing each day?  Where would you be?  Would it make a difference what time of year it was?  What if it was longer than a week?  Would it still look the same?

When you are caught up in the day to day life of raising a family, many decisions are put on autopilot.  There are just so many choices to be made that you need autopilot just to keep your sanity.  But, in doing that, you keep going to work to get the paycheck to do the other things that are also on autopilot.  You get in a mode of believing that you must do A so that you can do B so that you can get to C on time.  And let’s face it – routines are a big part of what gets us through everyday life. 

But now the routine is being upended anyway.  Let’s step back and look at what comes next because you want to make it happen – not because it happens to you.  Don’t worry about what the standard path is.  No one says you must follow standard path – except maybe you.  Most people continue on the path that they’re on because it’s easier to just keep going.  That doesn’t mean it’s the only path or the best path – it just means that they have a lot of company. 

I’m not saying that you can definitely go out tomorrow and live the exact life you pictured for your vacation.  But, imagine that you go out tomorrow and have a new purpose.  Your new purpose is building that life that you pictured. Rather than simply going to work each day so that you can get to the day that you retire, you start each day with a purpose that is specific to you.  Imagine how much easier it is to greet each day knowing that you’re not just working, you’re working toward YOUR goals. Imagine knowing that the energy you expend each day is getting you closer to where YOU want to be.  The time is going to pass anyway – spend it building the life you envision.

Once you have had the courage to design your ideal life, call me.  Let’s talk about what’s possible – without the constraints that you put on yourself.  Let’s see what steps you can take once you give yourself permission to build your ideal life.

 

P.S. You’ll be setting a great role model for your kids too.