Why Take A Loan From Your Retirement Plan
You should take loans from your retirement plan only if you have exhausted your other financing options, or if the loan will help to improve your finances. For instance, if you had balances of $20,000 with an interest rate of 15% and you could afford to pay $400 per month, it might make good financial sense to take a loan from your retirement plan in order to pay off your credit card balances.
Let’s compare the two scenarios.
|Retirement Plan Loan Amount|
While it is true that the $2,351.41 you pay in interest on your loan amount will be double taxed, the obvious benefit is that the interest will be repaid to you, instead of to a credit card company, and the amount you pay in interest will be significantly lower.
If you do take a loan from your retirement account to pay off your , make sure you take steps to avoid accruing new indebtedness under the credit cards. Check with your financial planner for assistance in this areathey can also help you ensure that your .
Another good reason for taking a loan from your retirement account is to use the loan amount to purchase a home. As industry trends show, amounts invested in your home provide a significant return on investment. Furthermore, you could also use your home to finance your retirement, whether by selling the home or by taking a reverse mortgage.
Not All 401 Plans Will Allow You To Borrow
Not all 401 plans allow you to borrow against your retirement account. If your employer doesnt permit it, you wont have this option available to you.
Further, while the CARES Act allows employers to enable larger loans, it doesnt require them to do so. Even some 401 administrators that generally permit borrowing may not double the loan limits.
Youll need to check with your plan administrator to see if youre allowed to borrow at all and, if so, how much you can borrow.
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Failing To Repay A 401 Loan
If you fail to make scheduled payments for a 401 loan, the entire remaining balance of the loan will be treated by the IRS as a distribution. Also, if you leave your job before repaying the loan, you have a limited amount of time to repay it or it will be treated as a distribution. A 401 loan thats treated as a distribution is classified as taxable income by the IRS. In addition, workers below age 59 1/2 in this situation are subject to a 10 percent IRS penalty for early withdrawal from their retirement account. Retired workers with reduced incomes should carefully consider 401 loan repayment after leaving the job to avoid the tax penalties for defaulting.
Better Options For Emergency Cash Than An Early 401 Withdrawal
It can be scary when suddenly you need emergency cash for medical expenses, or when you lose your job and just need to make ends meet.
The money squeeze can be quick and traumatic, especially in a more volatile economy.
Thats why information about an early 401 withdrawal is among the most frequently searched items on principal.com. Understandably so, in a world keen on saddling us with debt.
But the sad reality is that if you do it, you could be missing out on crucial long-term growth, says Stanley Poorman, a financial professional with Principal® who helps clients on household money matters.
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.
In short, he says, You may be harming your ability to reach and get through retirement. More on that in a minute. First, lets cover your alternatives.
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When Faced With A Sudden Cash Crunch It Can Be Tempting To Tap Your 401 More Than A Few Individuals Have Raided Their Retirement Account For Everything From Medical Emergencies To A Week
But if youre under 59-1/2, keep in mind that an early withdrawal from your 401 will cost you dearly. Youre robbing your future piggy bank to solve problems in the present.
Youll miss the compounded earnings youd otherwise receive, youll likely get stuck with early withdrawal penalties, and youll certainly have to pay income tax on the amount withdrawn to Uncle Sam.
If you absolutely must draw from your 401 before 59-1/2, and emergencies do crop up, there are a few ways it can be done.
You are allowed to make withdrawals, for example, for certain qualified hardships though youll probably still face a 10% early withdrawal penalty if youre under 59-1/2, plus owe ordinary income taxes. Comb the fine print in your 401 plan prospectus. It will spell out what qualifies as a hardship.
Although every plan varies, that may include withdrawals after the onset of sudden disability, money for the purchase of a first home, money for burial or funeral costs, money for repair of damages to your principal residence, money for payment of higher education expenses, money for payments necessary to prevent eviction or foreclosure, and money for certain medical expenses that arent reimbursed by your insurer.
Most major companies also offer a loan provision on their 401 plans that allow you to borrow against your account and repay yourself with interest.
You then repay the loan with interest, through deductions taken directly from your paychecks.
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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If You Take A 401 Loan You’ll Pay Interest To Yourself
When you borrow against your 401, you have to pay interest on your loan. The good news is that you’ll be paying that interest to yourself. Your plan administrator will determine the interest rate, which is usually based on the current prime rate.
The bad news is that you will pay interest on your 401 loan with after-tax dollars. When you take money out as a retiree, you are still taxed on the distributions at your ordinary income tax rate. This means the money is effectively taxed twice — once when you earn it before using it to pay back your loan and then again when the withdrawal is made.
The interest you pay yourself is generally also below what you would earn if you had left your money invested.
Why Take A 401 Loan
When you need cash and are having trouble getting approved for a loan, taking out a 401 loan may seem like a good idea. These loans have fairly generous repayment terms and are not contingent upon credit approval. You can apply for up to $50,000 without worrying if a bank is going to stick you with a high interest rate or decline your application.
Although a 401 loan is not ideal compared to some alternatives, it is better than others. These are some common reasons when a 401 loan makes sense:
- Need the money for the short term. If you can repay the loan in less than a year, it makes sense to avoid loan fees or higher interest rates of some loan options.
- Avoiding a payday loan. When a payday loan is your only other alternative, a 401 loan helps you avoid predatory fees and interest rates charged by payday lenders.
- Your credit score is bad. Some people have such a high debt that their credit scores are trashed. Taking out a 401 loan allows you to pay down your debt and reduce your credit utilization and improve your credit score. Once your score is higher, you might be able to qualify for better rates and terms from a traditional lender to repay your 401 loan.
- Down payment for a home. Normal 401 loans must be repaid within five years. But, when you borrow from your 401 to buy a home, you can stretch the payments out for up to 25 years.
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Take A 401k Loan: What You Should Know
Borrowing against funds in your plan may be allowed. But is it ever a good idea?
After years of regular contributions, a 401 plan through your employer may become one of your largest financial assets. In some cases, your employer may also allow you to borrow against the funds in that plan, which may be another financial benefit to you.
As you continue to work and build for your retirement, you may be tempted to take a loan to cover emergencies or big expenses like college. But before you make that decision, there are some things you should know about 401k loan rules.
Potential Benefits Of A Margin Loan
Some of the reasons you might consider using margin as a loan source include:
- Speed and convenience. Once your account is approved for margin, you can access a margin loan immediately, or at any time later on, without new forms or application fees.
- Relatively low interest rates. Margin rates, which use a base lending rate and a premium or discount based on the amount borrowed, can be broadly similar to rates on home equity loans for many investors, depending on loan size. And both are usually lower than the interest rates on unsecured loans, such as credit cards. Margin rates are typically on a tiered schedule, so that the higher the borrowing amount, the lower the rate. The amount you can borrow is variable, depending on the securities you pledge as collateral, and also subject to regulatory limits.
- Repayment flexibility. So long as you maintain the required level of equity in your account , you can pay back margin loans on your schedule. There is no monthly principal payment required and no term in which you need to repay the loan, although youre allowed to repay part or all of your loan at any time.
- Potential tax advantages. Margin loan interest may be tax deductible depending on your situation.1 Consult your tax advisor to learn more.
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What Are The 401k Loan Repayment Rules
There are requirements for repayment of a 401k loan. First, the money has to be repaid, usually over a five-year period. If you quit, are laid off, or if the 401k plan is terminated, the loan will typically become due within 60 days. This could be a big financial strain on you in addition to setting back your retirement saving.
Another drawback is that if the loan is not repaid when due, then the balance will be treated as a withdrawal, and may be subject to income tax as well as a 10% penalty tax if you are younger than 59 1/2 years old.
Loans & Hardship Distributions
As a participant in the Stanford Contributory Retirement Plan , you may be eligible to take a loan from your account balance held in Fidelity and Vanguard funds. Loans give you the opportunity to borrow from your account balance, and then repay yourself.
You may take out a loan against your account balance in your Tax-Deferred Account and/or Contributory Retirement Account, as long as your funds are with Vanguard or Fidelity. To request a loan you must have a total account balance in these funds of at least $2,000. Fidelity and Vanguard funds are subject to certain rules and restrictions, including those set by the U.S. Internal Revenue Service.
TIAA does not allow loans from their investment options.
NOTE: The following information pertains to ordinary loans and hardship distribution rules you may have alternative options in 2020 as provided in the Coronavirus Aid, Relief, and Economic Security Act. Read more about the CARES Act distribution and loans in this FAQ.
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To Borrow Or Not To Borrow
You can borrow money from your retirement plan and pay the funds back with lower interest rates than other types of borrowing, such as a credit card. However, a loan may trigger fees, and you may be forced to pay back the entire amount you borrowed if you leave your job, voluntarily or not. You also need to find out how your employer structures these types of loans.
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.
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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.
Caveats To Borrowing From Your 401
Some 401 plans allow a withdrawal in the form of a loan, but some do not. You must check with your 401 plan administrator or investment company to find out whether your plan allows you to borrow against your account balance. You can usually find their contact information on your statement.
Some companies allow for multiple loans.
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Borrowing Against A : What To Consider
Sarah Brodsky, March 2017
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 it’s appropriate to tap into that money, and it allows you to borrow from a 401 with some limitations.
How Does A 401k Loan Work
When you take out a 401 loan, that portion of your balance is liquidated from your investments. Typically this is done proportionately from each of your different investments. Some plans allow you to designate which investments to use for the loan.
The loan proceeds are either deposited into your bank account or a check is mailed to your home address. Once the funds are in your bank account, there are no restrictions on how that money can be spent.
The typical 401 loan term is five years, which is the maximum repayment term that the government allows. However, you can request a shorter term, you may be able to request one. If you are using the money to buy a home, some plans allow your loan to be up to 25 years.
Your loan payments are generally taken automatically from your 401 contributions each pay period. By law, you must make at least one substantially equal payment every quarter.
401 loans charge interest on the outstanding balance. Generally, the rates are 1% to 2% higher than the Prime Rate. The interest that you pay is credited to your 401 account, so you are actually paying yourself the interest on the loan. These interest payments help to offset the loss of market returns on the amount liquidated to fund your loan.
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Can I Take Out A Loan On My 401
Some 401 plans allow you to borrow against your 401 to meet your financial needs, in exchange for a promise to repay the borrowed amount to your account. If you apply for a loan, it must meet the terms set out in your plans loan policy. Typical terms include a maximum loan of up to 50% of your vested account balance , and repayment within 5 years. The interest rate set for your loan will be interest that you pay back to your own account .
Its important to note that plans often require full repayment of the loan upon termination of employment, so if you think a job change may be in your future, consider whether youll be able to repay the loan out of pocket or plan for the tax bill due if you cannot.
While many plans allow participants to take out a loan on their account, it is important to remember that 401 plans are designed to help ensure that you have enough money set aside for retirement.
Your Summary Plan Description can provide more information on what types of withdrawals your plan allows, and you can see more information about loans you may be eligible for by selecting your 401 account in the withdrawal flow here.
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