The New Rules Of Borrowing Money From Your 401 And Better Options To Consider
The COVID-19 pandemic has caused millions of people to lose their jobs or temporarily stop earning an income. The halt in cash flow means you or any of your friends and relatives cant afford basic necessities, like making home payments and buying food.
If there were no global pandemic, experts would be singing in unison to avoid borrowing money from your 401 or 403. But desperation and hardship are very real for millions of Americans. If youve emptied your emergency fund and your checking and savings accounts are exhausted, taking a 401 loan to cover current costs may be your next best alternative.
Heres what you need to know about 401 loans and taking out money from your retirement accounts before you retire.
What Is A 401k Plan Loan
A 401k plan loan is one of a few ways you can borrow money from your 401k early without incurring a penalty.
While 401k plan loans will vary depending on which plan your company offers, a few rules are constant:
- The maximum amount you can take from your 401k is 50% of the vested account amount.
- You may borrow no more than $50,000.
- If 50% of your vested account amount is less than $50,000, you can withdraw up to $10,000.
- You must repay the loan within five years.
Youre borrowing the money from your future self when you take a 401k loan and your future self is going to want that money back with interest.
Thats because when you take the money out, its no longer compounding and accruing interest. This means you will lose the gains on any amount you borrow. The interest rate is there to compensate for the loss in gains.
Now lets take a look at how to borrow from your 401k.
Withdrawals From A 401
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401 hardship withdrawals If you find yourself facing dire financial concerns and need cash urgently, your 401 plan may offer a hardship withdrawal option. Unlike a 401 loan, you wont have to repay the money you take out, but you will owe taxes and potentially a premature distribution penalty on the amount that you withdraw. In addition, IRS 401 hardship withdrawal rules state that you may not take out more money than what is needed to cover your hardship situation. In order to qualify for a 401 hardship withdrawal, your plan administrator must offer this option and you must be facing an immediate and heavy financial need. According to the IRS, approved 401 hardship withdrawal reasons include:
- Postsecondary tuition for you or your family
- Medical or funeral expenses for you or your family
- Certain costs related to buying, or repairing damage to, your primary residence
- Preventing your immediate eviction from or foreclosure of your primary residence
If you experience a financial hardship from a circumstance not on this list, you may still be able to qualify for a hardship withdrawal, so check with your plan administrator.
- In-service, non-hardship withdrawals
This type of withdrawal is only allowed under certain plans and is mainly used by those who would like to explore other investment options. Learn more about in-service distributions. An Ameriprise financial advisor can provide more detailed information on in-service 401 distributions.
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Think About What Would Happen If You Lost Your Job
This is really important. If you lose your job, or change jobs, you cant take your 401 loan with you. In most cases you have to pay back the loan at termination or within sixty days of leaving your job. This is a big consideration. If you need the loan in the first place, how will you have the money to pay it back on short notice? And if you fail to pay back the loan within the specified time period, the outstanding balance will likely be considered a distribution, again subject to income taxes and penalties, as I discussed above. So while you may feel secure in your job right now, youd be wise to at least factor this possibility into your decision to borrow.
Smart Move: To lessen the odds of having to take a 401 loan, try to keep cash available to cover three to six months of essential living expenses in case of an emergency.
Most People Have Two Options:
- A 401 loan
- A withdrawal
Whether youre considering a loan or a withdrawal, a financial advisor can help you make an informed decision that considers the long-term impacts on your financial goals and retirement.
Here are some common questions and concerns about borrowing or withdrawing money from your 401 before retirement.
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- Obtaining a plan loan is usually easier than getting a loan from a bank or other commercial lender. If you have the required minimum balance in your account and meet your plans other requirements, you should qualify.
- Most of the interest you pay on a plan loan goes back into your plan account, with a percentage used to pay for the loan administration.
- In some cases, you can repay the loan through payroll deduction, so you dont have to remember paperwork or repayment schedules. In other cases, youll be given a coupon book to help you remember to make payments.
Always check with your plan administrator to learn about the exact terms of your plan and take note of any fees you may be charges, as well as any other restrictions.
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What Other Options Are There If You Need Cash
- If you have a Roth IRA for five years, you can withdraw your original contributions at any age, free of federal taxes and penalties.
- For education expenses, explore scholarships or student loans.
- You can borrow for school but not for retirement.You can borrow against the value of your home with a home equity loan or home equity line of credit.
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How Do You Take A Withdrawal Or Loan From Your Fidelity 401
If you’ve explored all the alternatives and decided that taking money from your retirement savings is the best option, you’ll need to submit a request for a 401 loan or withdrawal. If your retirement plan is with Fidelity, log in to NetBenefits®Log In Required to review your balances, available loan amounts, and withdrawal options. We can help guide you through the process online.
Never Pull Money From Your 401 Except In These 3 Cases
- Average account balances have hit a high of $92,500.
- If you leave your job, the loan may become due.
- Make sure you can handle the repayments.
Here’s a personal finance rule you can break with reservations: Taking a loan from your 401 plan.
Aside from your house, your workplace retirement plan likely makes up the largest chunk of your overall wealth. The average 401 balance in the fourth quarter of 2016 hit an all-time high of $92,500, according to data from Fidelity Investments.
In a perfect world, you’d want to let your account ride as long as it can, taking advantage of market cycles over time and steady deferrals from your pay each week.
However, certain emergencies and long-term planning goals call for the more drastic step of borrowing from your 401, as was the case for Greg Walton.
The 32-year-old IT support engineer at the Massachusetts Institute of Technology borrowed $7,000 from his 401 in order to pay off a student loan with a higher interest rate and which had gone into default at one point.
Walton is repaying the loan directly from his paycheck.
“Plan participants understand that the money is sacrosanct, but they may find themselves in a situation where the 401 is the largest source of capital they have,” said James A. Cox, financial advisor at Harris Financial Group in Richmond, Virginia.
Here’s how to borrow from your 401 without ending up with a big tax bill.
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How Much Can Be Borrowed From A 401 Loan
It depends on how much you have in your account. You can borrow up to 50% of your vested account balance, but you cant borrow more than $50,000. Even if you have a balance of $200,000, the IRS wont let you touch more than $50,000 of it.
The only time you can borrow more than 50% is when you have a balance of less than $20,000. In that case, you can borrow up to $10,000, even if you only have $10,000 stashed away.
Should You Borrow From Your 401k
Instead of a withdrawal, you can consider borrowing from your 401k. While employer rules do vary, generally, you can borrow a maximum of half the balance up to $50,000 and repay it over five years. The benefits of borrowing against your retirement are:
- The interest rate is generally only a point or two over market rates.
- The interest you pay goes back into your 401k.
- You arent subject to taxes or penalties.
While this may be more advantageous than a personal loan, its not without risk. This is a potential option if you are 100 percent confident that you wont be leaving your job for the time it takes you to repay the loan. If you default, it wont hurt your credit, but you will be required to pay the taxes and penalties on the balance of the loan. You also lose out on growth to your investment.
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Loan Vs 401 Withdrawal
You should utilize a 401 loan if you intend to pay the money back to your retirement account. However, if you’re just looking to take money out for an expense, this would be considered a withdrawal.
Withdrawing money early from your 401 is often not recommended since you’ll be subject to fees and taxes if you’re not at least age 59 ½.
Let’s look at an example of how a 401 loan would work: Let’s say you needed $25,000 immediately to pay off high-interest debt and you have a vested 401 balance of $60,000. If you took out a 401 loan, you could receive a maximum of $30,000 .
But in this case, you could borrow $25,000 from your plan , which would leave you with a 401 balance of $35,000 in your plan, and no taxes or penalties would be due related to your loan. Assuming the loan has a five-year term, a 5% interest rate, and you pay back your loan through bi-weekly payroll deductions, you’ll make a payment every pay period of $235.89 . That means you’d end up repaying $28,306.85 in total .
After five years, your loan will be fully paid off and your 401 account will now include all the loan and interest payments you made .
“Some plans have hardship withdrawals, which provide funds in very specific emergency cases, but you must have an immediate and heavy financial need,” says Riesenberg.
Riesenberg also adds that if you are allowed a hardship withdrawal from your 401 account, you’re not required to pay the 10% early withdrawal penalty.
Those Who Truly Need It
It really comes down to need. If you need to withdraw your money, then withdraw your money. Thats really the essence of the CARES Act. It simply makes a need-based withdrawal less harmful. If you dont need to, then dont, says Brandon Renfro, a financial advisor and assistant professor of finance at East Texas Baptist University.
Its important to consider what things will be like after you take a withdrawal and once things are back to a new normal. Under the CARES Act, you have to repay your withdrawal within three years. If you just need a withdrawal to get you through the next few months before you start earning regular paychecks again, it could be a good option.
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How To Borrow From A 401
Your first step when considering borrowing from your 401 is to contact your employer benefits department or your 401 plan provider to get details on how your plan’s loans work .
Here’s what to look for in 401 loan rules:
Financial update:
As long as you adhere to the mandates, all should go well. But if you don’t, your loan could be considered a withdrawal, and tax payments and penalties will follow.
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What To Do Before Withdrawing From Your 401
Even if you qualify for an early distribution, you should be wary of withdrawing from your 401.
So before borrowing from your 401, where should you look for money? The first and obvious place to look is liquid, cash savings, Levine says. Ideally, everyone would have an emergency fund for situations like this.
If you dont have enough saved up, then take a look at your current spending you may find areas where you can scale back to save money while times are tough.
Do you have a car payment or lease that you could reasonably get rid of by buying a cheaper or used car? Are you living in a rental that you could move out of and into something cheaper? Those are obviously serious steps, and just examples, but withdrawing from a 401 will permanently reduce your savings, says Renfro.
If you cant cut anything out of your budget, you could try to get discounts. Levine suggests calling providers, like your cable and insurance companies, and explaining that you need to cut back due to coronavirus-related cash flow issues. Theyll almost definitely offer a discount, he says.
You could also consider taking out a small loan, but be careful not to get yourself further behind with a high-interest debt payment, Renfro says.
Borrowing Against A : What To Consider
Sarah Brodsky
Ideally, money that you put into a 401 is supposed to stay there until you retire. The IRS imposes a number of restrictions and penalties on early distributions that are meant to dissuade people from pulling their funds out early. Still, the government recognizes that there are times when its appropriate to tap into that money, and it allows you to borrow from a 401 with some limitations.
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Factor In Whenand Howyou Have To Pay It Back
Youre borrowing your own money, but you do have to pay it back on time. If you dont, the loan is considered a taxable distribution and youll pay ordinary income taxes on it. If youre under 59½, youll also be hit with a 10 percent penalty. Put that in real dollars: If youre 55, in the 25 percent tax bracket, and you default on a $20,000 loan, it could potentially cost you $5,000 in taxes and $2,000 in penalties. Thats a pretty hefty price to pay for the use of your own money!
Before borrowing, figure out if you can comfortably pay back the loan. The maximum term of a 401 loan is five years unless youre borrowing to buy a home, in which case it can be longer. Some employers allow you to repay faster, with no prepayment penalty. In any case, the repayment schedule is usually determined by your plan. Often, paymentswith interestare automatically deducted from your paychecks. At the very least, you must make payments quarterly. So ask yourself: If youre short on cash now, where will you find the cash to repay the loan?
Getting A 401 Loan For A Home
If you’d like to use your 401 to cover your down payment or closing costs, there are two ways to do it: a 401 loan or a withdrawal. It’s important to understand the distinction between the two and the financial implications of each option.
When you take a loan from your 401, it must be repaid with interest. Granted, you’re repaying the loan back to yourself and the interest rate may be low, but it’s not free money. Something else to note about 401 loans is that not all plans permit them. If your plan does, be aware of how much you can borrow. The IRS limits 401 loans to either the greater of $10,000 or 50% of your vested account balance, or $50,000, whichever is less. For example, if your account balance is $50,000, the maximum amount you’d be able to borrow is $25,000, assuming you’re fully vested.
In terms of repayment, a 401 loan must be repaid within five years. Your payments must be made at least quarterly and include both principal and interest. One important caveat to note: loan payments are not treated as contributions to your plan. In fact, your employer may opt to temporarily suspend any new contributions to the plan until the loan has been repaid. That’s significant because 401 contributions lower your taxable income. If you’re not making any new contributions during your loan repayment period, that could push your tax liability higher in the interim.
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