Why Borrowing From Your 401 Is Almost Always A Bad Idea:
Borrowing From A 401k Loan Fees & Cost
Ballpark Estimate: Up to $350 in plan fees for a 5-year loan plus the cost of interest
If you are in need of money for some sudden or unexpected expenses, you may be tempted to borrow from your retirement account. This can be an easy-to-access source of funds to get you through an emergency situation. Yet some experts warn that this loan doesnt come without significant costs and responsibilities. Therefore, you should be prepared to get all of the facts before deciding if this is your best option.
Can A Loan Be Taken From An Ira
Loans are not permitted from IRAs or from IRA-based plans such as SEPs, SARSEPs and SIMPLE IRA plans. Loans are only possible from qualified plans that satisfy the requirements of 401, from annuity plans that satisfy the requirements of 403 or 403, and from governmental plans. Reg. Section 1.72-1, Q& A-2)
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If You Default On Your 401 Loan Youll Owe A Penalty
If you do not pay your 401 loan back as required, the defaulted loan is considered a withdrawal or distribution and thus is subject to a 10% penalty applicable to early withdrawals made before age 59 1/2. Thats potentially a huge cost, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
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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.
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Required Minimum Distribution Method
This will result in an annual payment to the recipient. The account balance is divided by the life expectancy factor of the recipient to arrive at the annual amount. The amount is recalculated each year based on the new account balance, but the life table used in the original calculation is used for the duration of the payments.
Pros And Cons Of Borrowing From Your 401
Experts note investing steadily over the long term is the best way to ensure you have funds for retirement. So its a good idea to carefully consider the pros and cons of borrowing from your 401.
Pros
- A 401 loan doesnt trigger a hard credit inquiry from the credit reporting firms and doesnt appear on your credit report.
- Interest rates are set by the plan administrator and can be less than other kinds of loans.
- Interest on the loan goes back into the 401. You pay your own account for the loan.
- If you miss a payment on a 401 loan it wont impact your credit score
- If you use the loan to pay off high-interest credit cards and pay the 401 loan back on time, you could reduce the amount you pay in interest overall.
Cons
- If you lose your job, you may have to repay the loan in full.
- Similarly, if you lose your job and dont repay the loan by that years tax deadline, the IRS may consider your loan a withdrawal. If youre younger than 59 ½, youll likely owe a 10% early withdrawal tax penalty.
- You can end up with a smaller retirement nest egg. Thats because investment gains will build off a smaller base while your loan is outstanding.
- If you stop contributing to the plan during the loan, you may miss out on matching funds offered by some employers.
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How Borrowing From Your 401 Works
Most 401 programs let you set up a loan all on your own, without any assistance, via the website you use to handle other 401 tasks, such as changing your contribution amounts and allocating your savings to different investment funds.
Setting up the loan is as simple as finding the loan page on the 401 site and specifying the amount you want to borrow. The online form won’t let you borrow more than you’re entitled to, and interest rate and payroll deduction payments based on a standard five-year repayment period will be calculated automatically.
Once you authorize the loan, the amount of the loan will likely be included with your next paycheck .
If you have any questions about the process, you’ll find an option for contacting fund administrators on the webpage.
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.
- Avoid taxes or penalties. 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.
- Dodge credit checks. 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.
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Maintaining A 401 After Retirement
When an employee who has a 401 retires, the plan administrator has several options for handling the retirees account. The account balance may be paid out in a lump-sum distribution, or it may be paid out on a schedule over time. Another option is for the administrator to leave the 401 in place and allow the employee to make withdrawals on their own schedule. If the plan administrator continues to maintain the account, even after the employee has left the job, then it may be possible for the employee to borrow from the account if the administrator allows such loans.
Hardship Withdrawal Vs 401 Loan: An Overview
Is it ever OK to borrow 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. Indeed, data from Fidelity shows that the average account balance has climbed to $112,300, as of February 2020.
The recently enacted CARES Act lets you make a penalty-free COVID-19 related withdrawal or take out a loan from your 401 in 2020 with special repayment provisions and tax treatment.
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.
Before you pull the trigger, though, its important to understand the financial implications of tapping your retirement plan early. There are two basic avenues for taking some money out before reaching retirement age.
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What Are The Disadvantages Of Borrowing Money From Your 401
- If you don’t repay your plan loan when required, it will generally be treated as a taxable distribution.
- If you leave your employer’s service and still have an outstanding balance on a plan loan, you’ll usually be required to repay the loan in full within 60 days. Otherwise, the outstanding balance will be treated as a taxable distribution, and you’ll owe a 10 percent penalty tax in addition to regular income taxes if you’re under age 59½.
- Loan interest is generally not tax deductible .
- In most cases, the amount you borrow is removed from your 401 plan account, and your loan payments are credited back to your account. You’ll lose out on any tax-deferred investment earnings that may have accrued on the borrowed funds had they remained in your 401 plan account.
- Loan payments are made with after-tax dollars.
How Does Borrowing From My 401 Work
The IRS and your employer determine the conditions for a loan. The IRS sets the maximum you can borrow: $50,000, or 50% of your balance, whichever is less. Your spouse may need to sign that they agree to the loan.
In most plans, you can access the funds in a few days. Repayment is generally on a 5-year schedule, although often you can pay the loan off faster without incurring prepayment penalties. As long as you pay off the balance in time, you wonât pay taxes or penalties for accessing retirement funds early.
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Is There A Limit On 401 Loans
Plans can set their own limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
For example, if you have $150,000 vested in your 401 account, then you wouldnt be able to borrow the full 50%, or $75,000, of your vested balance. The most you could borrow in that scenario would be $50,000.
On the other hand, if 50% of your vested account balance amounts to less than $10,000, your plan may include an exception and allow you borrow up to $10,000.
You may be able to take more than one loan from your 401, but the total amount of your loan balance cant exceed these limits.
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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When To Choose A 401 Loan
- You cant beat the price. If your 401 offers a loan at 4%, but your bank cant offer better than 8%, borrowing from your 401 could be a strong consideration.
- Speed and convenience are a priority. With no credit checks and fast access to funds, these loans can help those on tight timelines.
- Youre out of other options. If other sources of money have come up dry, your 401 loan can save the day.
Request A Hardship Withdrawal
In certain circumstances you may qualify for whats known as a hardship withdrawal and avoid paying the 10% early distribution tax. While the IRS defines a hardship as an immediate and heavy financial need, your 401 plan will ultimately decide whether you are eligible for a hardship withdrawal and not all plans will offer one. According to the IRS, you may qualify for a hardship withdrawal to pay for the following:
- Medical care for yourself, your spouse, dependents or a beneficiary
- Costs directly related to the purchase of your principal residence
- Tuition, related educational fees and room and board expenses for the next 12 months of postsecondary education for you, your spouse, children, dependents or beneficiary
- Payments necessary to prevent eviction from your principal residence or foreclosure on the mortgage on that home
- Funeral expenses for you, your spouse, children or dependents
- Some expenses to repair damage to your primary residence
Although a hardship withdrawal is exempt from the 10% penalty, income tax is owed on these distributions. The amount withdrawn from a 401 is also limited to what is necessary to satisfy the need. In other words, if you have $5,000 in medical bills to pay, you may not withdraw $30,000 from your 401 and use the difference to buy a boat. You might also be required to prove that you cannot reasonably obtain the funds from another source.
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If You’re Thinking About Borrowing From Your 401 Consider The Pros And Cons First
- Borrowing against your 401 is generally frowned upon, but in some circumstances, it can make sense.
- When you take out a loan from your 401, you dont have to fill out a lengthy application, the interest rate is typically lower than it is for a personal loan or business loan, and there arent any penalties.
- A big downside of borrowing against your 401 is that it harms your retirement saving potential. During the repayment period, you are barred from contributing to your 401.
- This article is for business owners and professionals who are thinking about borrowing money from their 401 retirement fund.
Ask most financial advisors about borrowing from your 401, and their response will be brief and blunt: Dont do it.
Those three words mostly sum up the prevailing sentiment on the subject. Still, there are some situations in which borrowing from your 401 might make sense. If youre considering taking out a loan against your plan, know the pros and cons first.
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When To Do It
Ironically, the best time to borrow against your 401 to pay closing costs or cover a down payment is when you can well afford to, suggests David Hultstrom, a financial adviser in Woodstock, Georgia. Otherwise, you are stretching yourself to the point where you couldnt weather an emergency.
If you lose your job and couldnt repay the 401 loan, you would have to take that amount as a distribution. That would cost you income tax and a 10 percent penalty on the amount and it would also leave your retirement plan permanently lighter, as you wouldnt be able to replace that money when you got onto more solid ground.
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Next Steps To Consider
This information is intended to be educational and is not tailored to the investment needs of any specific investor.
Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.
Fidelity Brokerage Services LLC, Member NYSE, SIPC, 900 Salem Street, Smithfield, RI 02917
A Deeper Dive On The 401 Loan Option
A loan is more strategic than a withdrawal, which torpedoes your savings altogether. With a full cash-out, instantly you lose a big chunk, paying a 10% penalty to the IRS if you leave the plan under age 55 plus another 20% for federal taxes. For instance, with a $50,000 withdrawal, you may keep just $32,500 and pay $17,500 in state and federal taxes. And the leftover sum you receive, if you happen to be in a higher tax bracket, may nudge you into paying even more taxes for that additional annual income.
Another adjustment in 2020 for workers affected by COVID-19: If your plan allows or through your IRA, you can withdraw up to $100,000 without the 10% penalty even if youre younger than 59½. The standard 20% federal tax withholding does not apply, but 10% withholding will unless you decide otherwise. You also can spread your income tax payments on the withdrawal over three years.
We understand emergencies can leave people with limited choices. Just remember that even the less extreme option of a 401 loan may paint your future self into a corner. The most severe impact of a 401 loan or withdrawal isnt the immediate penalties but how it interrupts the power of compound interest to grow your retirement savings.
At the very least, dont start stacking loans . Some employer retirement plans allow as many as three.
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