Bad Reasons To Borrow Against A 401k
If youre borrowing money for ordinary expenses that should be part of your budget like mortgage or rent payments you have a spending problem. These are not unexpected expenses they are what it costs to live your life. You either need to spend less money or make more, ideally both.
Your 401k is also not an emergency fund. You should have at least $1000 in an emergency fund and ultimately six months worth of expenses. That is the money you use for an unexpected expense like a significant car or home repair.
Your 401k is not a source of discretionary spending. Do not pay for things like a vacation or a house full of new furniture. Those are things you have to save up for. Your 401k isnt savings its retirementsavings.
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Why Do People Get 401 Loans
As long as a plan allows it, participants generally can borrow from their 401 for any reason that they deem necessary. Some plans may only allow loans for specific reasons, so be sure to check your plans rules before trying to borrow.
Since youre borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401 loan as long as you meet the plans requirements for borrowing. In some cases, a requirement may be getting approval from your spouse , because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401 loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesnt mean 401 loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
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The Risks Of Borrowing From Retirement Funds
One risk is that you could lose your job, not be able to pay back the loan in time and get hit with taxes and penalties. Also, before determining how much you can afford to borrow, take into consideration that when you’re paying back the loan, you’ll be able to afford 401 contributions on top of your loan payments. Then you may end up contributing less to your 401 during your career. And of course, a downside of borrowing from a 401 is that the money you borrow doesn’t earn an investment return for you until you pay it back. The nature of investments and compound earnings is that it’s always better to invest sooner rather than later, so taking money out now and paying it back in the future can lower the amount you have available for retirement.
Understand The Limits On How Much You Can Borrow
Just because you have a large balance in your 401 and your plan allows loans doesnt mean you can borrow the whole amount. Loans from a 401 are limited to one-half the vested value of your account or a maximum of $50,000whichever is less. If the vested amount is $10,000 or less, you can borrow up to the vested amount.
For the record, youre always 100 percent vested in the contributions you make to your 401 as well as any earnings on your contributions. Thats your money. For a company match, that may not be the case. Even if your company puts the matching amount in your account each year, that money may vest over time, meaning that it may not be completely yours until youve worked for the company for a certain number of years.
Example: Lets say youve worked for a company for four years and contributed $10,000 a year to your 401. Each year, your company has matched 5% of your contribution for an additional $500 per year. Your 401 balance would be $42,000. However, the companys vesting schedule states that after four years of service, youre only 60% vested. So your vested balance would be $41,200 . This means you could borrow up to 50% of that balance, or $20,600.
Now lets say that after ten years of service, youre fully vested and your balance has grown to $120,000. The maximum you could borrow is $50,000.
The government sets these loan limits, but plans can set stricter limitations, and some may have lower loan maximums. Again, be sure to check your plan policy.
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Most People Have Two Options:
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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How To Access Your Money In An Emergency
Are you hesitating to invest in a retirement plan because you want access to your money if you need it? While retirement plan savings should be preserved for retirement, you might be able to take out your money early for other needs. If your plan allows a loan or hardship withdrawal, its important to know you can use your savings in an emergency.
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Will A 401 Loan Affect My Credit
Taking out a 401 loan has no direct impact on your credit scores.
- You don’t need a credit check to qualify for a 401 loan, so taking one out doesn’t trigger a hard inquiry and result in a temporary dip in credit scores.
- Payments on 401 loans are not tracked by the national credit bureaus , so they do not appear in your credit reports and cannot factor into credit score calculations. If you miss a payment or even default on the loan, your credit scores will not change.
Note, however, that the extra tax and penalty expenses that come with a 401 loan default can make it difficult to pay your credit bills, which can jeopardize your credit standing indirectly.
The Spouse Did Not Consent To The Loan
Though not mandatory, some companies may require spousal consent to approve a 401 loan above a certain threshold, usually $5,000.
If your employer requires spousal consent to approve a loan, they will include a spousal consent form as part of the 401 loan documentation. The spouse must fill this form, and it should be returned alongside your loan application paperwork.
If you return the loan application paperwork without the spousal consent form, the plan administrator will reject the 401 loan application. Since a 401 is considered marital property, plan administrators may require spousal consent to avoid legal tussles.
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How Much Can You Borrow From 401
Most companies allow employees to take 401 loans, but there are companies that donât allow 401 loans. If your company allows 401 loans, you may be able to borrow up to the IRS limit. You can borrow up to 50% of the total of your contributions and the vested portion of the employerâs contributions.
The IRS imposes lower and upper limits on how much you can borrow from your 401. Usually, you can borrow no more than $50,000 if you have a 401 balance of $100,000 or more. However, if your accrued benefits fall below $10,000, you can only borrow up to $10,000. Some employers may decide to set lower 401 limits for their plans, but these limits should not exceed the maximum amount allowed by the IRS.
An exemption to the IRS limit is theCARES Act during the COVID-19 pandemic, which allowed employees to borrow 100% of their vested balance up to a maximum limit of $100,000, whichever is less.
Why Not To Borrow From Your 401 Retirement Plan
While there are a few reasons that make borrowing from your 401 a good idea, this is something you should keep in mind:
Your 401 is not an emergency fund or a source of discretionary spending.
A retirement account is meant to support you through your golden years. When you find yourself faced with lifes unexpected expenses, a personal loan on the other hand could be exactly what you need to pay off debt and get back to focusing on your financial goals. Why jeopardize your retirement savings if you do not have to? If a personal loan can solve your needs, it is the better and less risky option.
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Youve Already Exceeded Your Loan Limit
As mentioned earlier, theres always a limit to the amount of money you can borrow from your 401k.
If youve previously taken out a loan and are seeking a new one, the new loan should bring the total amount you owe up to 50% of your vested account balance, or $50,000. If it causes your debt to exceed this amount, then the new loan wont be approved.
Some plan administrators wont even allow new loan applications for up to six months after fully repaying your previous loan.
Others wont allow you to take out more than one 401k loan at a time and will reject new applications until you clear the existing debt and wait for at least six months. This might be longer or shorter depending on the employer.
Repayment Terms For 401 Loans
Just like other loans, funds obtained from a 401 account must be paid back, plus interest. Unlike a loan from a bank, the interest paid goes to the 401 account itself. With the majority of employers, loan payments cannot be extended past a five-year term and are made through paycheck deferrals. In some cases, such as a loan for a down payment on a home, repayment may be extended past the five-year maximum.
If an individual leaves their job prior to repaying the loan, they have until October of the following year to put the money back. If the loan is not repaid within that time frame, it is designated as a premature distribution of funds and is thus subject to income taxes, plus a 10% early withdrawal penalty for borrowers under age 59½.
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Impact Of 401 Loan On Retirement
Some 401 plan administrators freeze an employees contributions to a 401 while a loan on the account is being repaid. This action would not pertain to a retiree who was no longer making contributions. Even so, unless the market performs poorly while your loan is active, you may lose more in compound interest on the 401 money you borrow than you will pay in interest on a conventional bank loan. If you are unable to repay the loan on schedule, you could face a big tax bill when the outstanding balance is treated like a distribution by the IRS.
Withdrawals Are An Alternative To 401 Loans
A 401 loan is generally preferable to a 401 withdrawal if you must use the funds in your retirement accounts to meet your immediate needs. A loan is a better alternative because:
- You avoid the 10% early withdrawal penalty that applies if you take money out of your 401 before age 59 1/2.
- You’ll repay the money to your 401 so it will not permanently lose out on all of the investment gains it could have earned between the time of the withdrawal and the time you retire.
Before considering a 401 withdrawal and incurring both the penalties and losing gains for the remainder of the time until retirement, you should seriously think about taking out a loan instead if your plan allows it.
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Drawbacks To 401 Loans
Assuming the loan and repayment process goes perfectly smoothly, there are several major reasons you should think twice before borrowing from your 401 fund:
- A 401 loan uses money that should be invested and helping accumulate wealth for your retirement. The funds you pull out of your 401 cannot gain investment value, and the interest payments you’re making to yourself are unlikely to come close to matching the gains you’d make in a moderately successful stock or index fund. contribution or invest elsewhere.)
- For most borrowers, retirement savings get put on hold until the 401 loan is repaid. Payroll deductions for 401 loan repayment typically eliminate or greatly reduce 401 payments for the five years it takes to pay off the loan. Losing five or so years of retirement savings, and likely forfeiting some or all of your employer’s matching contributions to your 401 in the process, is potentially a huge setback in your retirement savings process. The goal with 401 plans, as with all long-term savings programs, is to stash funds in small, steady amounts over long periods of time, and let money accumulate through the power of compound growth and reinvestment. A 401 loan disrupts that process in a major way, and most funds can never fully recover.
If your 401 loan process doesn’t go smoothly, you could face even worse consequences:
Reasons To Borrow From Your 401
Although general financial wisdom tells us we shouldnt borrow against our future, there are some benefits to borrowing from your 401.
- With a loan from a commercial lender such as a bank, the interest on the loan is the price you pay to borrow the banks money. With a 401 loan, you pay the interest on the loan out of your own pocket and into your own 401 account.
- The interest rate on a 401 loan may be lower than what you could obtain through a commercial lender, a line of credit, or a credit card, making the loan payments more affordable.
- There are generally no qualifying requirements for taking a 401 loan, which can help employees who may not qualify for a commercial loan based on their credit history or current financial status.
- The 401 loan application process is generally easier and faster than going through a commercial lender and does not go on your credit report.
- If you are taking a loan to buy a home, you can have up to 30 years to repay the loan with interest.
- Loan payments are generally deducted from your paycheck, making repayment easy and consistent.
- If you are in the armed forces, your loan repayments may be suspended while you are on active duty and your loan term may be extended.
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What Happens If You Leave Your Job
When you take out a loan from a 401, you may have no intention of leaving your current employer. But if you receive a better job offer, or are laid off or otherwise leave, you could be required to pay the loan back in full or face some serious tax consequences.
Employees who leave their jobs with an outstanding 401 loan have until the tax-return-filing due date for that tax year, including any extensions, to repay the outstanding balance of the loan, or to roll it over into another eligible retirement account. If you cant repay it, the amount of money you still owe will be considered a deemed distribution and could be taxed as it would be if you were to default on the loan.
That means if you left your job in January 2021, you would have until April 18, 2022 when your 2021 federal tax return is due to roll over or repay the loan amount. Prior to the Tax Cuts and Jobs Act of 2017, the deadline was 60 days.
If you cant repay the loan, your employer will treat the remaining unpaid balance as a distribution and issue Form 1099-R to the IRS. That amount is typically considered taxable income and may be subject to a 10% penalty on the amount of the distribution for early withdrawal if youre younger than 59½ or dont otherwise qualify for an exemption.
