| | Borrowing Against A 401K Account December 1, 2006 |
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Borrowing money against a 401K account can be a way of finding cash for emergencies that you didn’t know existed, and as long as you follow the rules and are careful there should be no financial danger. The 401K is after all set up for your benefit, so using it for benefit now as well as at retirement just means you are getting more use out of it and more bang for your buck.
Many people wonder exactly what a 401K account is. A 401K is a retirement account that you contribute to yourself. In many cases your employer also contributes a set amount, usually matching a previously announced percentage of your salary that you put in. Federal income taxes on this money are deferred until you actually make a withdrawal and withdrawals cannot be made until standard retirement age, usually seen at age 59 and a half. And when withdrawn, only the amount taken out of the account is taxed at any given period allowing you to control the rate of taxation. For instance, if you have $100,000 in your 401K at age 60 and decide to withdraw only $10,000 per year, then each year the ten grand you withdraw will be subject to taxation while the remaining money continues to earn interest with taxes deferred. This sounds very much like the traditional IRA or individual retirement account for very good reason. The two types of accounts are very much alike. But the 401K is managed by a person’s employer and not by the individual. There are many other accounts available for self-employed people that are very much like the 401K. They include the Simple IRA and the SEP or Self Employed Pension. These accounts are in essence simplified versions of the 401K designed for very small businesses. There are also versions of the 401K account designed for those employed by non-profit organizations. And there is a cousin called the Roth IRA, which is the only retirement account that is not tax deferred. With a Roth IRA after taxes are paid money is placed into the account, but that account is never taxed again, allowing it to accrue large amounts of money over the years since the interest and principle are not taxed, and quickly multiply.
If you have an emergency need coming up, for instance large medical bills, needing to send a child to college, an emergency repair that needs to be made to the house, or any other situation requiring cash then check into borrowing against a 401K account. Since the 401K is security against the loan, serving as collateral, the lender is more willing to make a generous loan. They have a safeguard in case of default in that they can claim the 401K if the loan is not repaid. This is much like the method used on a home mortgage, but in that case the house or building is used as collateral. So, you may well have strong collateral to use for a loan sitting in a bank account that you couldn’t access until retirement age, but which can do you a great deal of good now through a loan.
Also since early withdrawal of money from an IRA account means a penalty is paid to the federal government, generally a person cannot borrow 100% of the amount in the 401K. A smaller amount is generally borrowed to fully collatoralize the loan. The penalty for early withdrawal is ten percent, in addition to any taxes that are owed. There are however hardship reasons for early withdrawal that are recognized by the federal government. These include purchase of a primary home, though mortgage payments are not included, or foreclosure of or eviction from a home. Also payment of education expenses accrued during the previous 12 months for the account holder, a spouse or dependents, medical expenses that are not covered by insurance for the account holder, spouse or dependents, funeral expenses for the account holders parents, spouse or dependents, or home repairs due to major catastrophe.
The 401K plan has been around since 1978 when Congress amended the Internal Revenue Code to add the plans. While originally intended for executives, the plans proved so popular that they were quickly adapted for use by all workers. One reason of course is that the yearly contribution amounts were higher than those offered by IRA plans. Also the 401K proved to be much cheaper for employers to maintain than the traditional pension plan. A company matching funds program and the fact that funds in a 401K plan are protected from creditors should a person go through bankruptcy make it very attractive. The funds are protected, unlike some IRA plans.
While the term 401K refers to a section of the US tax code, the plans have become so popular than in many other countries they informally refer to retirement programs as 401K plans. These plans have become especially popular in Canada, Australia and Japan. So, even though there is no section 401 in the Japanese tax code, people in Japan still commonly refer to the program as the Japanese 401K.
Of course, no loan should be taken on lightly. Lenders always qualify the lendees and encourage them to be absolutely certain that a loan is the right solution for them. However, if a loan will solve problems for you and you have a 401K account then borrowing against the 401K may be the most efficient and effective way to acquire the funds that you need. Paying the loan back in a timely manner can also help a person to achieve a higher credit rating, allowing them to borrow money in an easier manner in the future if the need should come up again. Borrowing against a 401K can be a help when you have money problems. If problems come up for you, then discuss the problem with a lender and see if borrowing against a 401K is the right move for you to make. It may well be and if it can solve your problems, that’s what a 401K account is there for anyway.
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