When folks are in financial distress, the first tendency is to look for sources of funds to pay bills or tide them over until they are back on their feet. Three sources that are often explored are:
- Taking cash out of a 401(k) plan.
- Taking a loan from the 401(k) plan.
- Taking a loan against the cash value in a life insurance policy.
Let’s look at each of these.
Taking cash out of a 401(k) plan
Most people are aware that if you take money out of your 401(k) account, those funds are taxable at your regular income tax rate. If you are younger than 59½ when you take the money out, you will also have to pay a 10% penalty for taking money out of your retirement account early. If you are in the 15% tax bracket and you take $3,000 out of your 401(k), you will owe $450 in federal income tax plus $300 for the penalty. Hence, you will lose $3,000 out of your retirement and only receive $2,250. If your state has an income tax, you will also have to pay state income tax.
Taking a loan from the 401(k) plan
Most 401(k) plans allow participants to take loans against the value of their account. When you take the money out of the account as a loan, you don’t have to pay tax on the funds. You will, however, be required to pay interest on the loan until it is paid. Many people feel this is a good option because they are essentially paying interest to themselves. When you consider the economic loss, however, you may change your mind.
Let’s assume you have $60,000 in your retirement account and it has been earning 6% average over the last few years. If you left the money in the account and didn’t contribute any more into it, at the end of one year you would have $63,600.
Now let’s consider that you took out a $3,000 loan and the interest rate on the loan is 4%. Your balance in your retirement account is now $57,000. You will earn $3,420 in returns at the 6% rate. You will pay into the account $120 in interest if you don’t pay any of the $3,000 back. At the end of the year, assuming you didn’t make any more contributions to your 401(k), you would have $60,540 instead of $63,600.
There is a second and bigger risk when you take a loan against your 401(k) account. If you change jobs or lose your job, your loan immediately becomes a distribution and you will owe income tax on the $3,000 taken out. If you are younger than 59½, you will also owe the 10% penalty. Having to pay an additional $750 in taxes just when you lost your job or started a new job could be a heavy burden.
Taking a loan from your life insurance’s cash value
When you take a loan against the cash value of your life insurance policy, there is no income tax or interest due. When the insured person dies, the death benefit will be used first to pay off the loan and then the remaining amount will go to the heirs, tax-free in most cases.
If the insurance policy is surrendered or lapses, the remaining cash value in the policy is used to pay the loan and any remaining balance is paid to the owner of the policy. The owner will have to pay income tax on any gain in the policy.
Let’s look at a simple example: You have a life insurance policy with $30,000 cash value and you take a loan of $20,000 against the policy. The premiums are $1,000 per year and you have been paying the premiums for 10 years so you have paid $10,000 in premiums. You decide to surrender the policy and take out the remaining cash value. The insurance company will pay you $10,000 ($30,000 cash value less the $20,000 loan). Your taxable gain is $20,000 ($30,000 cash value less the $10,000 you paid in premiums). You will have to pay tax on that $20,000 even though you only received $10,000 when you surrendered the policy.
Are you considering taking a loan against your retirement plan or life insurance policy? Would you like more information so you can make an informed decision? Contact us at [email protected] or 402-502-0250.Judith Ackland has more than 26 years of experience in accountancy and financial planning, including seventeen years as a CFO of a diverse business. She started Crystal Financial in 2010 to help a wide array of individuals, families, and business owners better understand their finances and how good financial management could help them achieve their goals. Judith has an MA in Professional Accountancy from the University of Nebraska at Lincoln as well as a Certified Public Accountant Certificate and a Certified Financial Planner designation.