Make A 401 Withdrawal
Your second option would be to make a direct withdrawal from your 401 account. As mentioned above, this is the less desirable of the two options.
An early withdrawal would be classified as a hardship withdrawal. The IRS considers any emergency removal of funds from a 401 to cover an immediate and heavy financial need as a hardship withdrawal. Whether or not the purchase of a home using your 401 counts as a hardship withdrawal is a determination that falls to your employer, and you will need to present evidence of hardship before the withdrawal can be approved.
Regardless, you will still likely incur the 10% early withdrawal penalty. There are exemptions in place for specific circumstances, including home buying expenses for a principal residence. Qualifying for such exemptions is difficult by design, however. If you possess other assets that could be used for your home purchase, then you likely wont qualify for an exemption. Even if you do, your withdrawal will still be taxed as income.
What Happens If You Leave Your Job With An Unpaid 401 Loan
If you got a better job, or you were laid off or fired from your job, you may be required to pay back the loan a lot sooner than you had expected.
For example, if you leave your job in the third year of a five-year loan repayment period, you may be required to repay the outstanding loan before the federal tax due date. You can make a lump-sum payment to pay off the loan or increase the periodic loan payments to beat the April tax deadline.
If you canât pay the loan by the tax due date, the plan will treat the outstanding balance as a distribution. The unpaid loan will be taxed at your tax bracket rate, and you could owe an additional 10% penalty tax if you are younger than 59 Â½.
How Much Can You Borrow
The IRS sets limits on how much 401 participants can borrow against their retirement savings. Typically, you can borrow the greater of $10,000 or half of your vested balance, up to $50,000.
For example, if your vested balance is $200,000, you can borrow up a maximum of $50,000. However, if your 401 balance is $80,000, you can only borrow up to $40,000. Once you take a loan, the amount is deducted from your account balance, and you can rebuild the balance over time as you repay the loan.
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Will Your Employer Know If You Take Out A 401 Loan
Yes, its likely your employer will know about any loan from their own sponsored plan. You may need to go through the human resources department to request the loan and youd pay it back through payroll deduction, which theyd also be aware of. Loans arent guaranteed to be approved either or your plan may not offer them at all. If youre concerned about a manager or executive finding out about the loan request, consider asking HR to keep your request confidential.
What Are The Disadvantages Of Withdrawing Money From Your 401 In Cases Of Hardship
- Taking a hardship withdrawal will reduce the size of your retirement nest egg, and the funds you withdraw will no longer grow tax deferred.
- Hardship withdrawals are generally subject to federal income tax. A 10 percent federal penalty tax may also apply if you’re under age 59½. contributions, only the portion of the withdrawal representing earnings will be subject to tax and penalties.)
- You may not be able to contribute to your 401 plan for six months following a hardship distribution.
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Youre Risking A Balloon Payment Situation That Could Lead To Expensive Consequences
Its your employers plan. If you were to suddenly lose your job, the plan will most likely require you to pay the outstanding balance within 60 to 90 days.
If times get tough and youre not able to repay the loan in time, it will be counted as a withdrawal from your retirement savings. Youll have to pay income tax on the money, plus a ten percent penalty for early withdrawal if you are under age 59½ and the withdrawal did not qualify for an exception.
Of course, there may be times in your life in which it makes sense to borrow from your 401 for example, if youre truly in an emergency situation and cant secure cash elsewhere. But, borrowing from your future should always be your last option and one you dont exercise until youve considered all the risks.
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Four Ways To Minimize The Negative Effects Of A Loan
401 loans have unavoidable drawbacks, but you can lessen their impact by doing these four things:
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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.
Loans To Purchase A Home
Regulations require 401 plan loans to be repaid on an amortizing basis over not more than five years unless the loan is used to purchase a primary residence. Longer payback periods are allowed for these particular loans. The IRS doesn’t specify how long, though, so it’s something to work out with your plan administrator. And ask whether you get an extra year because of the CARES bill.
Also, remember that CARES extended the amount participants can borrow from their plans to $100,000. Previously, the maximum amount that participants may borrow from their plan is 50% of the vested account balance or $50,000, whichever is less. If the vested account balance is less than $10,000, you can still borrow up to $10,000.
Borrowing from a 401 to completely finance a residential purchase may not be as attractive as taking out a mortgage loan. Plan loans do not offer tax deductions for interest payments, as do most types of mortgages. And, while withdrawing and repaying within five years is fine in the usual scheme of 401 things, the impact on your retirement progress for a loan that has to be paid back over many years can be significant.
If you do need a sizable sum to purchase a house and want to use 401 funds, you might consider a hardship withdrawal instead of, or in addition to, the loan. But you will owe income tax on the withdrawal and, if the amount is more than $10,000, a 10% penalty as well.
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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.
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.
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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.
Better Options For Emergency Cash Than An Early 401 Withdrawal
We know it can be a struggle when suddenly you need emergency cash for medical expenses, student loans, or crushing consumer debt. The extreme impact of coronavirus on public health and the economy has only compounded some of the more routine challenges of consumer cash flow.
We get it. 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, an advice and planning manager for Principal® Advised Services who helps clients on household money matters.
In short, he says, Youre harming your ability to reach retirement. More on that in a minute. First, lets cover your alternatives.
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Loan Repayment After Termination
The IRS doesnt care if you quit your job, were laid off or were fired. The same rules apply in all cases you either come up with the money to pay back the loan by October of the year following your departure from work or face an early withdrawal tax hit. The one exception are people older than 59 ½ and are no longer subject to early withdrawal rules.
How Much Can I Borrow
In most cases, youre allowed to borrow up to half of your account balance, or $50,000 whichever is less. So, if you have $40,000 in your 401, you should be able to borrow up to $20,000. If you have $200,000 in your account, youd only be able to borrow up to the maximum $50,000. Be sure to only consider your vested account balance. You cant borrow against funds that your company contributed on your behalf if you dont yet have full rights to that money.
Its best to borrow as little as possible. Youll have to repay that loan, and smaller loans are easier to repay. Borrowing is always risky, and borrowing from a retirement plan is especially risky, as youll see below. However, you might only get one shot at borrowing, so you might not be able to borrow more if you need it in the future. That is, you might only be allowed to have one loan outstanding at a time, and there are some other intricacies that limit how much you can borrow if youve borrowed from your 401k plan in the recent past.
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Do You Need To Get Approved
The process of getting approved for a 401 loan is different from using a lender like a bank or credit union. Your employer does not evaluate your credit scores , your income, or your ability to repay the loan. As long as your plan allows loans and you can meet the requirements, you can borrow. You dont need to apply you just request the loan.
Bad credit, bankruptcy, and other negative items in your credit do not prevent you from borrowing. Again, you can use the money for anything you want . Still, it only makes sense to raid your retirement savings if you have a good reason. Dont use loans to fund wants. If you absolutely need the money for your current living expenses, itll be hard to replace that money later.
Your credit is not affected if you fail to repay a 401 loan. However, you may have other financial issues to deal with .
Loans Have Competitive Interest Rates
The interest rate on a 401 loan is often in the neighborhood of the prime rate, which is consistent with typical consumer loans. But youll pay back the loan principal and the interest to yourself, not to a bank or other financial institution. The entire amount of each loan repayment goes back into your 401 account.
This can a particularly attractive advantage if you’re taking the loan to pay off several high-interest credit cards and loansyou’ll save yourself money overall if your 401 loan rate is significantly less…and you get to keep that interest money in your plan rather than give it to someone else.
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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.
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.
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.
Bottom Line: Is Taking A 401 Loan A Good Idea
In most cases, taking a 401 loan is not a good idea. Unless a 401 loan is absolutely necessary, you may be better off looking elsewhere for financial resources. In addition to risking your retirement savings, you could wind up paying taxes and penalties that could easily be worth more than a third of your loan if you cant repay on time and in full.
Generally, its best to leave those retirement funds alone until youre ready to retire. This will keep your funds invested and avoid taxes and penalties, which is the best way to maximize your retirement savings during your working years. Once youre ready to retire, you can start to withdraw and get to work improving your fishing skills, or whatever it is you want to do when you retire.
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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 companys 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 employers 401 plan.
What If I Dont Repay
You dont necessarily have to repay 401 loans, but youll probably owe taxes and penalties if you dont. When its been decided that youre going to default on the loan , your loan becomes a distribution. It goes from being a temporary thing to a permanent thing you cant put the money back in the plan . If the money was pre-tax money, youll owe income tax on everything that has not been repaid, and you will likely also owe a 10 percent penalty on that amount. Assuming you owe $10,000 and your tax rate is 20 percent, youd owe $2,000 of income tax plus an additional $1,000 of penalty tax.
Loan offset: You may be able to pay off a loan by depositing funds in an IRA or another retirement account. To do so, you must make the rollover contribution before your tax filing deadline plus extensions . To use this strategy, you typically must have ended employment, or your employer may have terminated the 401 plan before you could repay the loan. Again, verify everything with your CPA before taking action.
In addition to taxes and returns, there are other reasons to avoid taking money out of a 401 plan. Especially if youre going to pay off debt, you give up some important benefits of your 401 plan when you take money out of it.
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