Have you been advised to invest in your company’s 401(k) plan? Or maybe you already have a 401(k) plan. There are financial experts who say a 401(k) plan is, without question, the best way to save for retirement. But there are also those that are critical of 401(k)s and say that they are the financial equivalent of drinking hemlock and should be marked with a skull and crossbones.
While both sides of this issue have valid points, there is no doubt about the fact that if you have a 401(k) and invest wisely it will help you harness the power of compounding interest.
What exactly is a 401(k)?
A 401(k) plan is an employer-established plan where you can defer some of your salary (salary reduction) by making contributions to the plan either post-tax or pretax. Your employer may or may not make matching contributions to your plan up to some percentage. Of course, the best type of 401(k) is where your employer does make matching contributions as this is basically free money.
You can borrow money yourself money
Another important advantage of a 401(k) is that you can borrow from it. However, this is where things get a bit sticky as there’s a fair bit of confusion about how loans from a 401(k) actually work such as tax issues, payback terms and how much compounding you would actually miss out on if you borrowed money from your 401(k). That said, here are four myths about borrowing money from a 401(k) that have been totally busted.
Myth #1: Borrowing money from your 401(k) can never be a win
If you were to borrow money from your 401(k) to pay off some high interest credit card debt that could be a definite win. As an example of this, suppose you have a credit card at 15% interest while the loan rate on your 401(k) is just 4%. If this were the case, you would not only save money by paying off that 15% credit card but you’d actually be paying the 4% interest to yourself. However, one of the financial myths that’s true is that interest you pay on the 401(k) loan comes directly out of your pocket and is after-tax dollars. So, it’s important to do the math as leaving that money in your 401(k) instead of paying off that credit card debt could actually make more sense. In addition, you need to see if you will be allowed to continue making contributions to your 401(k) so long as you have an outstanding loan. If this were the case it would make no sense at all to borrow money from your 401(k).
Myth #2: Borrowing money from your 401(k) never makes sense
There are financial experts that see this issue as black and white. 401(k) loans are just a financial “don’t”. But if there is a real need there – If you need the money to pay for your basic needs – then tapping your 401(k) may be better than getting a home equity loan or line of credit. The reason for this is simple. While you’ll owe interest on your 401(k) loan you’ll be paying it back into your account instead of a bank. Unfortunately, this interest is not tax deductible as is the interest on a credit card debt or personal loan. While the interest you pay on a 401(k) loan comes out of your pocket it’s still better than paying it to a third party.
Myth #3: You’ll be required to pay taxes twice
This is one of the biggest financial myths, It has been debunked a number of times but still seems to be still there confusing people. The idea behind this is that it’s double taxation because you’re putting pretax dollars in your 401(k) but then repaying the money with after-tax dollars. And of course, you’ll still owe taxes on the money when you pull it out during retirement. But this seriously exaggerates the tax cost of taking a loan from your 401(k). In fact, the only money that’s “taxed twice” is the interest you pay. But you’re taking the loan using money that’s never been taxed and there’s no tax consequence.
As an example of this, let’s say you borrow $10,000 from your 401(k) on Tuesday and repay the money in a month. You’ll pay no taxes on the money you withdraw and if you put the money right back into your account there’ll be very little tax consequences. In fact, the only after-tax money involved is the small amount of interest you’ll owe for the month you had the loan out.
If you have a 401(k) loan and lose your job, another of the financial myths is that you’d have to sell your home to repay the loan. First, you’ll have 60 days to pay back the money, which might be enough, depending on the size of the loan. What this suggests is that you should feel you’re really stable in your job before borrowing money from your 401(k). Beyond this, your 401(k) plan may give you extra time to pay back that loan if you lose your job. If you absolutely cannot come up with the money to repay the loan, then the unpaid loan amount will be subject to an early distribution penalty of 10% and you’ll have to pay ordinary income tax on the money. Those might not be totally serious consequences but they certainly beat having to sell your house to pay back loan, which is what some scare mongers would have you believe.
If you’re still uncertain about borrowing from your 401(k), here’s a brief video from Fidelity that discusses the pros and cons and well as some alternatives.
Frequently Asked Questions About 401(k)s
Q. What is salary deferral?
A. The simplest explanation of salary deferral is where you take some of your income and set it aside for later. The contributions you make to a 401(k) plan are normally made on a tax-deferred basis, meaning that your income is reduced by whatever amount of money you contribute to your plan. In short, you are not taxed on the money you contribute in any year you make a contribution.
Q. What is the 401(k) maximum this year?
A. The amount you can contribute to your 401(k) is limited by the IRS. And the amount is not a percentage of your salary. It’s a fixed number that applies to everyone. For example, this year the maximum yearly contribution for a yearly employee is $18,000 If you are under the age of 50. If you are older than 50 the maximum contribution goes to $24,000.
Q. What is a 401(k) Roth?
A Roth 401(k) is a sort of a hybrid that combines the features of a 401(k) plan with the Roth IRA. The biggest difference between it and a standard 401(k) is that the money you contribute is post-tax, which means that you will be required to pay taxes the year you contribute to the plan but the money will be tax-free when you retire and begin making withdrawals. It is similar to a standard 401(k) in that your employer may contribute matching funds.
Q. What does 401(k) stand for?
A. This plan was created under subsection 401(k) of the Internal Revenue Code, hence the name 401(k). If you sign up for your employer’s 401(k) plan the money you contribute will be automatically deducted from your paycheck before taxation, making it tax-deferred. However, unlike the Roth 401(k) plan the money will be taxed when you retire and begin making withdrawals.
Q. What is a 401(k) elective deferral?
A. Elective deferrals are the amounts you ask your employer to deduct from your pay and contribute on your behalf to the employer’s retirement plan. This is where you are setting aside part of your earnings pretax meaning that you won’t be required to pay taxes on your contributions. It is called an elective deferral because you get to elect how much you want deduced from your pay.
Q. What are 401(k) eligible earninggs?
A. The IRS generally usually sees eligible earnings as your gross income. However, depending on your employer this may or may not include bonuses. It doesn’t include supplemental benefits such as health insurance or a commuter allowance. You are allowed to contribute part of your eligible earnings to your 401(k) account, which increases every year. This year, as noted above, the maximum you can contribute of your eligible earnings is $18,000.
Q. What is 401(k) matching?
A. If your employer provides matching funds then 401(k) matching is the amount of money that it contributes to your 401(k). Typically, an employer will match 50% of your contributions for the first 6% of your salary that you contribute. This means the company is not matching more than 3% of your salary. However, some employers will match less than this.