Risks Of Taking Out A 401 Loan
Before deciding to borrow money from your 401, keep in mind that doing so has its drawbacks.
You may not get one. Having the option to get a 401 loan depends on your employer and the plan they have set up. A 2020 study from retirement data firm BrightScope and the Investment Company Institute says that 78 percent of plans gave participants the option to borrow based on 2017 data. So you may need to seek funds elsewhere.
You have limits. You might not be able to access as much cash as you need. The maximum loan amount is $50,000 or 50 percent of your vested account balance, whichever is less.
Old 401s dont count. If youre planning on tapping into a 401 from a company you no longer work for, youre out of luck. Unless youve rolled that money into your current 401 plan, you wont be able to use it.
You could pay taxes and penalties on it. If you dont repay your loan on time, the loan could turn into a distribution, which means you may end up paying taxes and bonus penalties on it.
Youll have to pay it back more quickly if you leave your job. If you change jobs, quit or get fired by your current employer, youll have to repay your outstanding 401 balance sooner than five years. Under the new tax law, 401 borrowers have until the due date of their federal income tax return to repay in such circumstances.
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Common 401 Loan Questions
Can I borrow against my 401? Check with your plan administrator to find out if 401 loans are allowed under your employers plan rules. Keep in mind that even though youre borrowing your own retirement money, there are certain rules you must follow to avoid penalties and taxes.
How much can I borrow against my 401? You can borrow up to 50% of the vested value of your account, up to a maximum of $50,000 for individuals with $100,000 or more vested. If your account balance is less than $10,000, you will only be allowed to borrow up to $10,000.
How often can I borrow from my 401? Most employer 401 plans will only allow one loan at a time, and you must repay that loan before you can take out another one. Even if your 401 plan does allow multiple loans, the maximum loan allowances, noted above, still apply.
What are the rules for repaying my 401 loan? In order to be compliant with the 401 loan repayment rules, youll need to make regularly scheduled payments that include both principal and interest, and you must repay the loan within five years. If youre using your 401 loanto buy a primary residence for yourself, you may be able to extend the repayment period. What if I lose my job before I finish repaying the loan? If you leave or are terminated from your job before youve finished repaying the loan, you typically have 60 days to repay the outstanding loan amount.
Summary of loan allowances
Pay On Your Extra Pay Periods
Maybe you have not thought about it before, but if you get paid weekly, you usually get four paychecks a month, and you will receive five paychecks every year for four months.
If you get paid biweekly, you typically bring home two paychecks a month. These extra paychecks are fun to spend on petty things, but they are perfect for paying down your loan debt. Remember the more you settle towards your loan, the faster you will get it paid off.
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Advantages Of Borrowing From A 401
Borrowing from your 401 isnt ideal, but it does have some advantages especially when compared to an early withdrawal.
A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis.
401 loans also wont require a credit check or be listed as debt on your credit report. If youre forced to default on the loan, you wont have to worry about it damaging your credit score because the default wont be reported to credit bureaus.
If You Lose Your Job You May Have To Repay The Money By Tax Day Next Year
Leaving your job used to trigger a requirement that you repay your loan within 60 days. However, the rules changed in 2018 under the Tax Cuts and Jobs Act. Now you have until tax day for the year you took the withdrawal to pay what you owe.
So, if you borrow in 2021, you will need to repay the full balance by April 15, 2022, or by Oct. 17, 2022, if you apply for an extension. If you borrow in 2022, you’ll have to repay the full balance by April 17, 2023, because April 15 of that year falls on a Saturday, or by Oct. 16, 2022, since the 15th of October falls on a Sunday.
This longer deadline does slightly reduce the risks of borrowing. But, if you take out a loan now, spend the money, and then are faced with an unexpected job loss, it could be hard to repay your loan in full.
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Traditional Rollover Sep And Simple Iras
If you are considering a withdrawal from one of these types of IRAs before age 59½, it will be considered an early distribution by the IRS.
In many cases, youll have to pay federal and state taxes. There may also be a 10% penalty unless you are using the money for exceptions such as a first-time home purchase, birth or adoption expense , qualified education expense, death or disability, health insurance , and some medical expenses. A 25% penalty may apply if you take a distribution within the first 2 years of opening a SIMPLE IRA.
If any of these situations apply to you, then you may need to fill out specific IRS forms. Always consult your tax advisor about your specific situation.
Best For Real Estate: Rocket Dollar
Rocket Dollar
Rocket Dollar allows you to invest in anything you can pay for with a checkbook. That means you can invest in real estate and other non-traditional assets while enjoying the tax advantages of a solo 401 account.
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Checkbook control allows you to invest in real estate and other alternatives
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Support for 401 loans and Roth contributions
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Option for upgraded account that includes free wire transfers, checks, tax form filing, and other features
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Basic accounts require $15 monthly fee and $360 setup fee
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Premium accounts require a $30 monthly fee and $600 setup fee
If you dont want the limitations of traditional financial markets, you may want to consider Rocket Dollar. Instead of stocks, ETFs, mutual funds, and bonds, Rocket Dollar accounts give you the control to buy any asset with your solo 401 that the IRS allows. That can include rental properties, fix-and-flip real estate, or land that you think will appreciate in value. You can invest outside of real estate as well, such as private investments in a startup or precious metals, however, Rocket Dollars flexibility makes it the solo 401 thats best for real estate.
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Know Where Youd Like Your Funds To Go
Many reasons may cause you to close a Fidelity account. Maybe you need to liquidate some funds for a purchase. Perhaps youre changing your investment strategy. Or perhaps youve switched jobs and your new 401 is with a different provider. Your reasons for closing your account will determine whether they transfer your funds to another financial services company or release them to you.
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Early Money: Take Advantage Of The Age 55 Rule
If you retireor lose your jobwhen you are age 55 but not yet 59½, you can avoid the 10% early withdrawal penalty for taking money out of your 401. However, this only applies to the 401 from the employer you just left. Money that is still in an earlier employers plan is not eligible for this exceptionnor is money in an individual retirement account .
If your account is between $1,000 and $5,000, your company is required to roll the funds into an IRA if it forces you out of the plan.
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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, itâs generally better to be paying interest to yourself than to someone else.
But 401 loans arenât without risks, the greatest being that if you canât 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.
Youâre 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, itâs not the best choice for everyone.
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Finally Use The 4% Rule
There are a few things to consider when deciding how much you can safely withdraw from your retirement savings each year without having to worry about running out of money later on. Just to name a few big factors, you need to consider your investmentsâ annual yield or total returns, your age at retirement, and how much money you get from other sources.
The most commonly used guideline is known as the â4% rule,â which says that if you withdraw 4% of your savings during your first year of retirement, then give yourself cost-of-living adjustments in subsequent years, the chance of running out of money within 30 years is small.
Just like the retirement income step we discussed earlier, this can be modified to fit your personal situation. For example, if you plan to retire early, your money will need to last longer, so you may want to use a 3% rule to be safe. On the other hand, if you retire late, or have lots of money coming in from other sources, withdrawing up to 5% per year might be the best move for you.
As a final step in calculating your retirement number, divide the amount of income youâll need from savings by your withdrawal rate, expressed as a decimal. For example, a 4% withdrawal rate would be 0.04 when converted to a decimal.
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Ways To Help Manage A Margin Line Of Credit
To ensure that youre using margin prudently, it may be possible to manage your margin as a line of credit by employing the following strategies:
- Have a plan. You should never borrow more than you can comfortably repay. Think about a process for taking out the loan and ensuring that it aligns with your financial situation, and consider how youll respond in the event of various market conditions. Among other things, you should know how much your account can decline before being issued a margin call. Find out more on managing margin calls
- Set aside funds. Identify a source of funds to contribute to your margin account in the event that your balance approaches the margin maintenance requirement. This can be anything from cash in another account to investments elsewhere in your portfolio .
- Monitor your account frequently. Consider setting up alerts to notify you when the value of your investments declines by an amount where you need to start thinking about the possibility of a margin call.
- Pay interest regularly. Interest charges are automatically posted to your account monthly. Its important to have a plan for reducing your margin balance to minimize the interest amount youre charged which you can do by selling a security or depositing cash into your account.
What Not To Do
In the worst of scenarios, you’ll borrow from your retirement plan, fail to repay it and end up with your finances in even worse shape.
Don’t borrow if you’re planning on leaving. Whether you quit your job or you’re fired, you may need to repay the whole balance of your loan within 60 days or else the amount borrowed is considered a taxable distribution.
Don’t ignore your debt-to-income ratio. Treat your plan loan the way you would any other extension of credit. The classic rule of thumb is that no more than 36 percent of your gross monthly income should go toward servicing debt.
This is known as the debt-to-income ratio.
Don’t blow off your plan’s rules for loans. A 2016 study from Aon Hewitt revealed that six in 10 employers have said they’d take steps to curtail the leakage of assets from retirement plans. Those actions include limiting the number of loans available or the amount of money that’s eligible for borrowing.
Plans can also establish their own repayment and schedules, which you’ll need to follow.
“When you take a 401 loan, it comes out of payroll and reduces your take home pay,” said Cox. “Either you follow the payment schedule or you fully remit the balance due.”
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When A 401 Loan Makes Sense
When you mustfind the cash for a serious short-term liquidity need, a loan from your 401 plan probably is one of the first places you should look. Let’s define short-term as being roughly a year or less. Let’s define “serious liquidity need” as a serious one-time demand for funds or a lump-sum cash payment.
Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America put it this way: “Lets face it, in the real world, sometimes people need money. Borrowing from your 401 can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loanor even a more reasonable personal loan. It will cost you less in the long run.”
Why is your 401 an attractive source for short-term loans? Because it can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan from your 401 is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your .
Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let’s dig a little deeper to explain why.
Hardship Withdrawal Vs 401 Loan: An Overview
Is it ever okay to take from your 401 plan, either as a 401 loan or a hardship withdrawal? After all, your plan is a powerful retirement savings tool and should be carefully handled. The primary advantage of saving in a 401 is the ability to enjoy tax-deferred growth on your investments. When youre setting aside cash for the long term, a hands-off approach is usually best. Nevertheless, there are some scenarios in which taking money out of your 401 can make sense.
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Youll Still Need To Be Mindful Of Taxes
Youll still owe income tax on your distribution from any tax-deferred retirement account. However, if you pay the distribution back within three years, you can file for a refund of the taxes you paid on that distribution.
Also worth noting: The income can be claimed all at once in 2020 for tax purposes, or spread evenly over the next three years. In many cases, dividing it evenly over three years may result in a better tax situation, as its less likely to bump you into a higher tax bracket in any single year.
If your income is expected to be lower in 2020 than the subsequent two years, though, it could make sense to claim all of the income on your 2020 tax return. Not only might this minimize the effective tax rate you pay on this income, but youll also have two years to pay back the distribution and ultimately get a refund.
Keep in mind that if you have a Roth IRA, it may still be a better choice for withdrawals than your 401 or IRA. Thats because savers can always withdraw contributions from their Roth IRA penalty- and tax-free.
