Q: Does It Make Sense To Borrow From My 401 If I Need Cash
When cash is tight, your 401 can seem like a perfectly reasonable way to make life a little easier. The money is there and its yoursso why not tap it to pay off debt or get out of some other financial jam? Or you might be tempted to use it to pay for that dream vacation you deserve to take.
Stop right there. The cash in your 401 may be calling youbut so is your financial future. The real question here: Will taking the money today jeopardize your financial security tomorrow?
Im not saying a 401 loan is always a bad idea. Sometimes, it may be your best option for handling a current cash need or an emergency. Interest rates are generally low and paperwork is minimal. But a 401 loan is just thata loan. And it needs to be paid back with interest. Yes, youre paying the interest to yourself, but you still have to come up with the money. Whats worse is that you pay yourself back with after-tax dollars that will be taxed again when you eventually withdraw the moneythats double taxation!
How Much Can I Borrow As A Second 401 Loan
IRS rules allow 401 participants to have two 401 loans at a time, as long as the total loan amount does not exceed the maximum loan limit. When evaluating how much a participant can borrow as a second loan, the employer considers the highest outstanding loan balance during the previous 12 months ending on the day before the second loan is issued. The total outstanding balance for both loans should not exceed $50,000, or 50% of the vested loan balance.
For example, assume that Mary has a vested balance of $98,000. She has an outstanding 401 loan balance of $5000, and the highest outstanding balance in the last 12 months was $10,000. When calculating the second 401 loan, the maximum allowed amount depends on the highest outstanding balance in the previous 12 months. If Mary plans to take another 401 loan, she qualifies to get $40,000 i.e. Maximum 401 loan limit â highest outstanding balance in the last 12 months.
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?
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Do You Have To Be Approved For A 401k Loan
When you apply for a loan, you must be approved for the 401 loan before you can receive the funds. Usually, once you send your 401 loan application, the plan administrator will review the application to determine if you qualify to borrow from your 401 and the amount you qualify to borrow. You can borrow up to 50% of your vested balance, up to a maximum of $50,000.
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An Example Of A 401 Loan
Suppose you have $5,000 in and $50,000 in a 401 plan. You borrow $5,000 and agree to pay off the debt within five years at an annual percentage rate of 4.25%. At the end of the five years, after having made payments of $92.65 a month, you will have replenished your account and paid yourself $558.83 in interest.
If you were to take the same amount of time to pay off the $5,000 of credit card debt, which had an annual percentage rate of 14.25%, using money left over after meeting your other expenses, you would have paid the card issuer $2,019.47 in interest after having made monthly payments of $116.99.
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What Happens If You Leave Your Job
If you leave your job with a 401 loan outstanding, you must repay the loan within 90 days. Otherwise, the remaining loan balance will be treated as a distribution and you’ll owe taxes and a 10% early withdrawal penalty on that amount. You will not be able to replace those withdrawals later on when you have more money. That means that you’ll also lose out on tax-deferred growth for that money that is offered through your 401.
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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How Often Can You Borrow From 401
If your employer allows multiple 401 loans, you can borrow more than one loan at a time. However, any new loan should not exceed the plan loan limit. 401 plans place limitations on borrowing from 401 over a 12-month rolling period. This means that, if you took two loans between February of the previous year and February of the current year, and you have used up the loan limit, you cannot borrow another loan in the same period even if you paid the first loan early. Hence, you will have to wait after the 12-month period to take another loan.
Youre Missing Out On Investment Growth
When you reduce the balance of your 401 account, you have less money growing along with potential gains in the market. In addition, some 401 plans have terms that prevent you from being able to make further contributions until the loan is repaid.
So not only are you missing out on potential gains on the amount you withdrew, you may also be slowing down the growth of your principal for the duration of your loan. If youve borrowed for the maximum term allowed five years all that inactivity can make a hefty dent in your retirement savings from which it can be difficult to recover.
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What Are The Borrowing Limits For A 401
In general, you can only borrow up to 50% of your vested account balance or $50,000, whichever is less. Some plans may offer an exception if your balance is less than $10,000 you may be allowed to withdraw the entire amount. With a withdrawal, there are no limits on the amount, assuming your plan allows you to do so.
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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.
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Alternatives To Borrowing From Your 401
Before you borrow from a 401 to buy a home, consider whether there are other options available. For example:
- Down payment assistance programs: Down payment assistance programs are designed to help eligible buyers with down payment and closing costs. Some programs offer grants to qualified buyers that don’t have to be repaid. Others offer matching savings programs, similar to a 401, that match every dollar you save towards your down payment, up to a certain amount.
- Down payment gifts: If you have family members who want to support your efforts to buy a home, consider asking them to gift money for a down payment. The amount of money that can be gifted and the amount you have to put towards the down payment out of your own funds may vary based on the type of mortgage. The most important thing to remember with down payment gifts is that they must be thoroughly documented. Otherwise, the lender might not allow you to use those funds for your down payment.
- IRA withdrawal: If you have an IRA, you can withdraw up to $10,000 from your account towards a down payment on a home without incurring the 10% early-withdrawal penalty. Be aware that if you’re withdrawing from a traditional IRA, you’ll still owe income tax on the amount you withdraw.
Who Gets The Interest Payments From A 401 Loan
You get the interest you pay on the 401 loans, since you are essentially lending money to yourself. Keep in mind that the interest payments are made with after-tax dollars. That’s a downside to 401 loans, because those after-tax dollars will be taxed again when they’re taken out as a 401 withdrawal in retirement.
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Borrowing From Your 401k Without Penalty
You may be wondering, how can I use my 401k to buy a house? There are two possible options: 401k withdrawals and 401k loans. Conventional wisdom advises against withdrawing funds from your 401k early. However, borrowing from yourself is different from withdrawing funds permanently and does not incur the same tax penalties as withdrawing funds.
In taking a 401k loan to purchase a home, you wont incur the same penalties. If you fail to repay your loan within the allotted time frame, however, it will be treated as a taxable withdrawal.
How Much Can You Borrow From Your 401
In general, you can borrow the greater of $10,000 or 50% of your vested account balance up to $50,000. You are limited to the balance in your current companyâs 401, not the collective balance of all of your retirement accounts. You may, however, be able to roll over funds into your current 401 to increase the amount you can borrow. You are limited to borrowing from the assets in your current employerâs 401 plan.
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Is It Better To Borrow From 401k Or Home Equity Loan
The cost of borrowing from your 401 is the amount you would have earned if youd kept the money in the 401K, also known as an opportunity cost. If you plan to use a HELOC or Cash-Out Mortgage Refinance, you avoid having the funds taxed as income and early withdrawal penalties associated with a 401 loan.
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Dividing Your 401 Assets
If you divorce, your former spouse may be entitled to some of the assets in your 401 account or to a portion of the actual account. That depends on where you live, as the laws governing marital property differ from state to state.
In community property states, you and your former spouse generally divide the value of your accounts equally. In the other states, assets are typically divided equitably rather than equally. That means that the division of your assets might not necessarily be a 50/50 split. In some cases, the partner who has the larger income will receive a larger share.
For your former spouse to get a share of your 401, his or her attorney will ask the court to issue a Qualified Domestic Relations Order . It instructs your plan administrator to create two subaccounts, one that you control and the other that your former spouse controls. In effect, that makes you both participants in the plan. Though your spouse cant make additional contributions, he or she may be able to change the way the assets are allocated.
Your plan administrator has 18 months to rule on the validity of the QDRO, and your spouses attorney may ask that you not be allowed to borrow from your plan, withdraw the assets or roll them into an IRA before that ruling is final. Once the division is final, your former spouse may choose to take the money in cash, roll it into an IRA or leave the assets in the plan.
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The Cares Act And 401 Loans
The Coronavirus Aid, Relief, and Economic Security Act, which became law on March 27, 2020, enables people who had taken out a 401 loan to delay for up to one year payments owed from that date through December 31, 2020. Interest would still accrue on your outstanding balance during the period of delayed payments.
The CARES Act also eliminated the 10% federal tax penalty on early withdrawals made from your 401 through the end of 2020.
The CARES Act enabled employers to increase the amount of a loan that employees could take against their 401 to $100,000 or the entire vested portion of their account, whichever was lower. However, that ability expired on September 22, 2020, and the maximum loan amount returned to $50,000 or 50% of the available amount, whichever is less.
To be eligible for any of the provisions of the CARES Act, you, your spouse, or your dependent must have been diagnosed with the coronavirus or its associated disease using a test approved by the Centers for Disease Control and Prevention . You also must have experienced financial hardship for one of the following reasons:
- You were quarantined, furloughed, or laid off, or your work hours were reduced due to the coronavirus pandemic.
- You were unable to work because of a lack of child care due to the coronavirus pandemic.
- You closed or reduced the hours of a business you owned or operated due to the coronavirus pandemic.
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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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.
