- A 401 (k) loan allows you to borrow money from your retirement account and pay it back within five years, with interest.
- A 401 (k) loan is not the same as a withdrawal, but there are specific rules to follow nonetheless.
- The funds borrowed under a 401 (k) loan will not increase, so you should only borrow funds as a last resort.
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Your retirement accounts are meant to save and invest money instead of borrowing it. However, if you find yourself in a situation where you need to borrow money and have few options, a 401 (k) loan may be useful for your situation.
A 401 (k) is an employer sponsored retirement plan that allows you to make pre-tax contributions. There are penalties for withdrawing money from your account before 59½, but you can borrow some of your 401 (k) money if you are able to follow a few specific rules.
What is a 401 (k) loan?
A 401 (k) loan is exactly what it sounds like – borrowing from your own 401 (k) account and paying yourself back over time. However, a 401 (k) loan is not a true loan because there is no lender assessment or credit score. Your 401 (k) business may have its own limits on loan amounts, but the IRS limits the amount you can borrow to the lesser amount: $ 50,000 or 50% of your vested 401 (k) balance.
However, you have to pay origination fees and interest – you will only reimburse them for yourself. To borrow money from your 401 (k), you need to ask your employer about their 401 (k) loan options and fill out the necessary paperwork.
401 (k) loan rules
There are a lot of important rules to keep in mind if you are going to use a 401 (k) loan.
- You can only borrow a maximum of $ 50,000 or 50% of your 401 (k) balance acquired over a 12 month period.
- A portion of the amount you borrow, plus interest, is withheld from each paycheck immediately after the loan funds are distributed to you.
- Borrowers typically have up to five years to repay the loan. (The only exception to this repayment term is if you are using the loan to purchase a primary residence.)
- If you lose your job during the repayment process, the remaining loan amount may be due immediately or on your next tax payment.
- If you are not able to repay your 401 (k) loan by the end of the tax year, the remaining balance will be considered a distribution and you will have to pay taxes as well as a penalty of 10 % early withdrawal fee on the amount. .
- Depending on your pension plan, you may need your spouse’s consent to borrow more than $ 5,000.
“The interest rate on 401 (k) loans tends to be relatively low, maybe a point or two above the
, which is less than [what] many consumers would pay for a personal loan, ”says Arvind Ven, CEO of Capital V Group located in California. “Plus, unlike a traditional loan, the interest doesn’t go to the bank or other commercial lender, it comes back to you. “
Ven also cautions that if you are unable to repay your 401 (k) loan, the brokerage firm that handles your 401 (k) will report it to the IRS on Form 1099-R.
“Until then, it’s being treated as a distribution that includes more fees, so it’s important to keep track of payments and stay on track.”
Advantages and disadvantages of a 401 (k) loan
Some people might say that getting a 401 (k) loan is a good idea, while others would disagree. This is why it is important to compare the pros and cons so that you can make the best decision for your situation.
You can quickly access funds when you need them. The biggest advantage of a 401 (k) loan is that you will have quick access to cash to cover expenses such as medical bills or home repairs. There is no credit check and the repayment rules are also flexible since payments are taken from your paychecks. You won’t have to worry about getting money back for loan repayments when you’re between paychecks.
Any interest paid is yours. “With a 401 (k) loan, you pay interest to yourself rather than to a third-party bank or credit card company,” says Bethany Riesenberg, CPA at Spotlight Asset Group. “In many cases the interest rate is lower than credit card rates, so it may be a good idea to take out a 401 (k) loan to pay off the high interest debt you have.”
Funds withdrawn will not benefit from market growth. The biggest downside is that the money you withdraw from your 401 (k) account will not increase. Even if you pay back the money within five years including interest, it may not make up for the money you lost if the market has grown at a higher rate on average over those five years.
You will have to pay a fee. Fees are another issue, because borrowing on your 401 (k) is far from free. Yes, you will pay yourself interest, but it is still extra money that you will have to hand over. Plus, you can pay a set-up fee as well as a maintenance fee to take out a 401 (k) loan based on your plan.
Payments made for the loan are taxed. Another thing to consider is that your loan payments are made with after-tax dollars (even if you use the loan to buy a home), and you will be taxed again when you withdraw the money later in retirement.
You may not be able to contribute to your 401 (k). “Some plans don’t allow you to continue contributing to your 401 (k) if you have an outstanding loan,” says Riesenberg. “This means if you take five years to pay off the loan, it will take you five years before you can add funds to your 401 (k), and you will have missed out on savings opportunities as well as the tax benefits of making contributions.” 401 (k). “
Additionally, if your employer makes matching contributions, you will also miss out on those during the years you are not contributing to your 401 (k).
You may have to pay immediately if you leave your employer. Finally, a major downside to consider is quitting your job before the 401 (k) loan is paid off. In this case, your plan sponsor may ask you to repay the entire 401 (k) loan. Additionally, the IRS requires borrowers to repay their 401 (k) loan balance in full by the date of filing the tax return for that tax year. If you are unable to meet these requirements, the amount may be withdrawn from your vested 401 (k) balance and treated as a distribution (subject to a 10% withdrawal penalty).
401 (k) loan vs 401 (k) withdrawal
You should use a 401 (k) loan if you intend to repay the money to your retirement account. However, if you are just looking to withdraw money for an expense, it will be considered a withdrawal.
It is often not recommended to withdraw money early from your 401 (k) as you will be subject to fees and taxes if you are not at least 59 and a half years old.
Let’s look at an example of how a 401 (k) loan works: let’s say you need $ 25,000 immediately to pay off high interest debt and you have an acquired 401 (k) balance of $ 60,000. If you took out a 401 (k) loan, you could receive a maximum of $ 30,000 (the lesser of $ 50,000 or 50% of your vested balance).
But in that case, you could borrow $ 25,000 from your plan (minus any additional fees), which would leave you with a 401 (k) balance of $ 35,000 in your plan, and no taxes or penalties would be due related to your. ready. Assuming the loan has a term of five years, an interest rate of 5%, and you pay off your loan through payday deductions every two weeks, you will make a payment every pay period of $ 235.89 $ ($ 471.78 per month). This means that you will end up paying off $ 28,306.85 in total ($ 25,000 + $ 3,306.85 [in interest] = $ 28,306.85).
After five years, your loan will be fully repaid and your 401 (k) account will now include all loan and interest payments you have made ($ 35,000 + $ 28,306.85 = $ 63,306.85).
Now let’s take an early 401 (k) withdrawal example instead: If you withdraw from your 401 (k), you will need to withdraw more money due to penalties and taxes for a net amount of $ 25,000. In this case, you will need to withdraw $ 39,683, resulting in taxes and penalties of $ 14,683 (assuming a federal tax rate of 20%, a state tax rate of 7%, and a penalty 10% early withdrawal). This means that your 401 (k) balance (originally $ 60,000) has dropped to $ 20,317, which is almost $ 15,000 less than it would be if you took out a 401 (k) loan.
“Some plans have hardship withdrawals, which provide funds for very specific emergencies, but you must have immediate and significant financial need,” says Riesenberg.
Riesenberg also adds that if you are allowed to make a hardship withdrawal from your 401 (k) account, you are not required to pay the 10% early withdrawal penalty.
The financial report
401 (k) loans could be a perfect way to pay off high interest debt or cover an emergency if you’ve exhausted all other options. On the other hand, borrowing from your retirement account comes with a lot of risk if you can’t afford to repay the loan or if you quit your job before the end of the repayment term.
In most cases, it’s safer to leave your retirement savings untouched and resort to other money borrowing options, whether it’s a low rate personal loan. 0% interest or APR credit card. Before deciding on a 401 (k) loan, you should also consult with a financial planner who can help you explore all of your options and also predict the impact of the loan on your future retirement.