What Is A 401 Withdrawal
A 401 withdrawal is, like it sounds, when you cash out a portion of the money in your account without the intent of replenishing the account. Pre-CARES Act rules state that youre required to pay a 10% early withdrawal penalty on top of the federal and state income taxes.
Under the CARES Act, 401 withdrawal rules have changed. The 10% early withdrawal penalty is being waived on hardship distributions. And you have three years to pay any taxes you incur from the withdrawal . Also, if you replenish your account within three years the CARES Act allows you to recover the taxes you paid on the early 401 withdrawal.
All that said, if youre going to withdraw money from a retirement account, your better choice is to tap your Roth IRA for cash first.
Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
What You Should Do Instead To Pay Off Your Credit Card Debt
In hindsight, Nitzsche says he would have handled his credit card debt differently, such as reaching out to the specific issuers to inquire about a financial hardship plan or participating in a debt management plan through a credit counselor.
He also recommends using balance transfer credit cards, which allow qualifying cardholders to move their credit card balances from one card to the next.
If you have credit card debt, this could be a good option as long as you have a plan to pay off the transferred balance within the card’s introductory no-interest period , otherwise you accrue more interest on top of that debt.
The Citi Simplicity® Card that offers 0% APR for the first 12 months on new purchases and 21 months for balance transfers . To qualify for these longer interest-free periods, you will most likely need to have good or excellent credit, but there are options available for fair credit as well.
The Aspire Platinum Mastercard® is one where applicants with fair or good credit may qualify, but the balance transfer period is shorter at only six months. After the intro period, there’s a relatively low variable APR of 9.65% to 18.00%.
Note that depending on your credit, you may not get approved for a credit limit high enough to cover the full balance of your debt. And while there are some balance transfer cards with no fee, most usually require a 2% to 5% fee .
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What To Ask Yourself Before Making A Withdrawal From Your Retirement Account
There are many valid reasons for dipping into your retirement savings early. However, try to avoid the mindset that your retirement money is accessible. Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. So before you take any money out, ask yourself: Do you actually need the money now?
Think of it this way: Rather than putting money away, you are actually paying it forward. If you are relatively early on in your career, your present self may be unattached and flexible. But your future self may be none of those things. Pay it forward. Do not allow lifestyle inflation to put your future self in a bind.
With all this talk of 10% penalties, and not touching the money until youre retired, we should point out that there is a solution if you feel the need to be able to access your retirement funds before you reach age 59 ½ without penalty.
Contribute to a Roth IRA, if you qualify for one.
Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Keep in mind that there are income limits on contributing to Roth IRAs, and that you will still be taxed if you withdraw the funds early or before the account has aged five years, but some people find the ease of access comforting.
For some folks, however, a Roth-type account is not easily available or accessible to them.
Should You Get A 401 Loan
Whether a 401 loan is the right for you depends on your situation. For some borrowers, especially those with poor credit, a 401 loan can help you avoid high-interest debt. As long as you can afford to repay the loan, its generally better to be paying interest to yourself than to someone else.
But 401 loans arent without risks, the greatest being that if you cant afford to repay the loan or leave your job early, you may have your loan converted to an early withdrawal. These carry the same possible 10% penalty and tax consequences as any other early withdrawal from a 401.
Youre also potentially missing out on up to five years of investment gains, depending on the length of your 401 loan. Remember that over the long term, the S& P 500 has gained an average of about 10% every year. While you could get lucky and make your 401 loan during an extended dip or recession, the longer your money is out, the more growth you may miss.
Before taking a loan from your 401, be sure to consider all other options, like emergency funds, taxable investment accounts, low-cost loans from personal lenders, HELOCs if you have home equity or any 0% APR credit cards you may be eligible for. While a 401 loan can make sense in some circumstances, its not the best choice for everyone.
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Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
Is Borrowing From 401k A Good Idea
Key Takeaways. When done for the right reasons, taking a short-term 401 loan and paying it back on schedule isnt necessarily a bad idea. Reasons to borrow from your 401 include speed and convenience, repayment flexibility, cost advantage, and potential benefits to your retirement savings in a down market.
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Possible Consequences If You Borrow From Your 401
Although paying yourself interest on money you borrow from yourself sounds like a win-win, there are risks associated with borrowing from your retirement savings that may make you want to think twice about taking a 401 loan.
- The money you pull out of your account will not be invested until you pay it back. If the investment gains in your 401 account are greater than the interest paid to your account, you will be missing out on that investment growth.
- If you are taking a loan to pay off other debt or because you are having a hard time meeting your living expenses, you may not have the means to both repay the loan and continue saving for retirement.
- If you leave your job whether voluntarily or otherwise, you may be required to repay any outstanding loan, generally within 60 days.
- If you cannot repay a 401 loan or otherwise break the rules of the loan terms, in addition to reducing your retirement savings, the loan will be treated as taxable income in the year you are unable to pay. You will also be subject to a 10% early distribution tax on the taxable income if you are younger than age 59½. For example, if you leave your employer at age 35 and cannot pay your outstanding loan balance of $10,000, you will have to include $10,000 in your taxable income for the year and pay a $1,000 early distribution tax.
Can I Use My 401 To Buy A House
For many would-be homeowners, the down payment is the biggest entry barrier to buying a house. While down payments can be as low as 3.5%, 20% is ideal if you want to secure a mortgage without monthly mortgage insurance fees.
If youre having trouble gathering funds for a down payment, you might find yourself considering using your 401 retirement fund as a convenient source of cash. While this is technically allowed, and could help you cover your down payment, there are some factors and drawbacks that you might want to consider.
Well break down the pros and cons of making a 401 withdrawal for a home purchase, as well as some alternatives.
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What Reasons Can You Withdraw From 401k Without Penalty
Qualifying medical expenses: If your expenses exceed a certain percentage of your adjusted gross income, you can withdraw funds penalty -free to cover them. Qualified domestic relations order: If a court orders you to give 401 funds to a spouse or dependent, you can withdraw the money penalty -free.
What Happens When You Default
401 providers allow participants to borrow up to 50% of their 401 retirement savings up to a maximum of $50,000. This means that, in the event of default, the 401 plan is protected and the employer can use the retirement savings to cover the outstanding loan balance. If you have a 401 loan that is at risk of becoming delinquent, you have two options to consider i.e. pay off the outstanding balance or let it default.
If you donât have the money to pay off the outstanding 401 loan balance, you can let the 401 loan default and deal with the tax consequences. The loan default is treated as a 401 withdrawal or distribution, which creates a tax liability. While the delinquent payment will not be reported to credit bureaus, you will owe taxes and penalties on the distribution. A bigger distribution will increase your annual earnings and push you to a higher tax bracket.
Also, if you are below 59 ½ at the time of default, you will be subject to a 10% federal tax penalty. However, if you quit your job at or after 55, you may be exempted from the penalty tax, but you will still owe income taxes at your tax bracket.
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How Long Do You Have To Repay A 401 Loan
Generally, you have up to five years to repay a 401 loan, although the term may be longer if youre using the money to buy your principal residence. IRS guidance says that loans should be repaid in substantially equal payments that include principal and interest and that are paid at least quarterly. Your plan may also allow you to repay your loan through payroll deductions.
The CARES Act allows plan sponsors to provide qualified borrowers with up to an additional year to pay off their 401 loans.
The interest rate youll pay on the loan is typically determined by the plan administrator based on the current prime rate, but it and the repayment schedule should be similar to what you might expect to receive from a bank loan. Also, the interest isnt paid to a lender since youre borrowing your own money, the interest you pay is added to your own 401 account.
Using 401k Funds For Down Payments
First-time home buyers who are unable to come up with a down payment can withdraw from their 401ks in order to gain access to funding quickly. When pulling from a 401k, borrowers only have access to the vested amount in their account, rather than the ending balance. This is simply because company matching funds may not be not immediately made available to pull from.
Withdrawing from your 401k before you hit retirement age always incurs penalties and fees. There are also different methods for withdrawing from your funding.
The hardship withdrawal option allows first-time home buyers to withdraw $10,000 from their 401k without incurring the 10% IRS penalty. However, buyers will have to pay income tax on this withdrawal come tax season.
The 401k loan option lets buyers borrower whichever of the below two options is less:
- 50% of the vested 401k balance
- Up to $50,000
Repayment terms are generally within 5 years and often come directly out of an employeeâs check.
A combination of the above two options can also be utilized if you have more than one 401k.
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Why Would Someone Take A 401 Loan
For some, the only alternative to a 401 loan is running up their credit card balance, and because credit card interest rates can reach the high teens and compound dailymeaning the interest you owe builds quickly401 loans are usually a cheaper option.
Your monthly and total payments on a credit card with 19% interest will be 33% higher than your payments on a five-year 401 loan with 5.75% interest.¹
Other potential advantages to a 401 loan include:
- No preapproval requirementA 401 loan can usually be processed online or over the phone, except in the case of a residential loan with a 10-year repayment, which may require paperwork.
- Interest payments go into your 401You pay interest to yourself.
- Repayment is automaticPrincipal and interest are repaid through payroll.
Find The Mortgage Option Thats Right For You
Your 401 account may seem tempting as an untapped source of cash, especially if youre struggling to come up with the money for a down payment on your new home. While this is a viable option, and there are ways to mitigate the penalties, it should only be used as a last resort. Consider applying for a low down-payment loan like an FHA or VA loan, or, if you have one, making a withdrawal from your IRA.
Whatever you decide, make sure you consult with a mortgage specialist before committing to an option. Rocket Mortgage® has experts waiting to help you navigate the tricky waters of home loans. If youre ready to take that next step toward a mortgage, then get started with our experts today.
Take the first step toward the right mortgage.
Apply online for expert recommendations with real interest rates and payments.
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Drawbacks To Using Your 401 To Buy A House
Even if it’s doable, tapping your retirement account for a house is problematic, no matter how you proceed. You diminish your retirement savingsnot only in terms of the immediate drop in the balance but in its future potential for growth.
For example, if you have $20,000 in your account and take out $10,000 for a home, that remaining $10,000 could potentially grow to $54,000 in 25 years with a 7% annualized return. But if you leave $20,000 in your 401 instead of using it for a home purchase, that $20,000 could grow to $108,000 in 25 years, earning the same 7% return.
Considering A Loan From Your 401 Plan
Your 401 plan may allow you to borrow from your account balance. However, you should consider a few things before taking a loan from your 401.
If you dont repay the loan, including interest, according to the loans terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job.
Generally, you have to include any previously untaxed amount of the distribution in your gross income in the year in which the distribution occurs. You may also have to pay an additional 10% tax on the amount of the taxable distribution, unless you:
- are at least age 59 ½, or
- qualify for another exception.
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