The Pros And Cons Of Borrowing From Your 401
Taking out a loan from your 401 plan can be the financial lifeline you need when you incur a large and unexpected debt. But tapping into your retirement account is a move that shouldn’t be taken lightly, and you should carefully consider the pros and cons.
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No minimum credit score is required.
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The money isn’t counted as a debt on your credit report.
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It may be cheaper than borrowing from a bank.
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You won’t pay income tax or a penalty tax on the withdrawn amount.
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You repay the loan with automatic paycheck deductions.
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Not all employers permit loans from their plan.
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There’s a limit on how much you can borrow.
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You may lose investment gains from the money you withdrew.
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You may feel tethered to your employer for longer than you want.
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Your withdrawn money will no longer be protected in the event you go bankrupt.
How To Get 401 Loans
The process of obtaining a 401 loan will vary depending on your plan provider. But since theres typically no credit check required, you can request information about the rates and fees associated with a 401 loan without hurting your credit score. Heres how to initiate the process.
Does It Make Sense
Lets address the elephant in the room first: Is it ever a smart idea to borrow money from your 401k? After all, the primary purpose of contributing to a 401k for most people is to save money for retirement. Could you be jeopardizing your financial security if you take out a 401k loan before you retire?
We generally say that yes, you possibly could put your future retirement security in danger. In fact, this is probably the biggest drawback to taking out a 401k loan. Borrowing money from your 401k means that you miss out on the potential earnings that could have accumulated in your account due to the long-term compounding of returns. We usually advise clients that the opportunity cost of borrowing against your 401k is simply not worth it in the long run and can have serious negative consequences on your ability to meet your retirement goals. To see what compounding interest can mean for your retirement nest egg over time, see The Average 401k Balance by Age.
Another reason that you should really avoid borrowing against your 401k if at all possible is that if you leave your job or are terminated before youve repaid the loan, you might have to pay income taxes and a penalty on the outstanding loan amount .
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Hardship Withdrawal Vs 401 Loan
When you borrow money from your 401 plan, you can pay it back over five years. The interest you pay goes back into your account. At the time you take a 401 plan loan, you will not pay taxes on the amount you borrow if the loan meets certain criteria.
If you do not pay back the full amount you borrowed according to the repayment plan, then any remaining loan amount will become a taxable distribution. It may also be subject to a 10% early withdrawal penalty tax .
Because of these differences, a 401 plan loan allows more flexibility than a 401 plan hardship withdrawal.
Can You Borrow From Your 401k
While you cannot withdraw from a 401 without paying interest and penalties, most 401 plans offer loans. To get a firm answer to this question about your 401 plan, you’ll need to speak with your company’s human resources or plan administrator. You can also log into your 401 account online to verify if this is an option for you.
Unlike a traditional loan from a bank or other lender, there are no credit requirements to borrow from a 401. As long as this feature is available and you have a large enough balance, you can qualify for a 401 loan. Additionally, 401 loans are not reported to the credit bureaus. Because of this, they will not build your credit, nor should they affect your ability to qualify for other loans.
In some states, your spouse may have to sign off on the 401 loan due to community property rules. This ensures that one spouse doesn’t spend money that they may have a claim to in case of a divorce.
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Leaving Work With An Unpaid Loan
Suppose you take a plan loan and then lose your job. You will have to repay the loan in full. If you don’t, the full unpaid loan balance will be considered a taxable distribution, and you could also face a 10% federal tax penalty on the unpaid balance if you are under age 59½. While this scenario is an accurate description of tax law, it doesn’t always reflect reality.
At retirement or separation from employment, many people often choose to take part of their 401 money as a taxable distribution, especially if they are cash-strapped. Having an unpaid loan balance has similar tax consequences to making this choice. Most plans do not require plan distributions at retirement or separation from service.
People who want to avoid negative tax consequences can tap other sources to repay their 401 loans before taking a distribution. If they do so, the full plan balance can qualify for a tax-advantaged transfer or rollover. If an unpaid loan balance is included in the participant’s taxable income and the loan is subsequently repaid, the 10% penalty does not apply.
The more serious problem is to take 401 loans while working without having the intent or ability to repay them on schedule. In this case, the unpaid loan balance is treated similarly to a hardship withdrawal, with negative tax consequences and perhaps also an unfavorable impact on plan participation rights.
Does A 401 Loan Or Withdrawal Make More Sense
When you consider the potential tax consequences associated with an early withdrawal, a 401 loan may seem more attractive. Of course, there’s one drawback with both options: you’re diminishing your retirement savings.
With a 401 loan, you’d have the ability to replace that money over time. If you’re cashing out an old 401, however, there’s no way to put that money back. In both cases, you’re missing out on the power of compound interest to grow your retirement wealth over time.
One upside of deciding to borrow from a 401 for a housewhether you take a loan or make a withdrawalis that it may allow you to avoid paying private mortgage insurance if you offer the lender a large enough down payment. Private mortgage insurance protects the lender, and it’s typically required if you’re putting less than 20% down on a conventional mortgage. Private mortgage insurance can be eliminated when you reach 20% equity in the home, but it can add to the cost of homeownership in the early years of your mortgage.
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How Do 401 Loan Repayments Work
If you decide to take out a 401 loan, make sure you understand how the loan repayment process works. Your loan payments are taken directly out of your paycheck, but there is a certain degree of risk involved. If for some reason, you cant make a payment for 90 days, youll incur significant penalties.
Its almost considered to be a short-term default because youll pay taxes on it and the 10% early withdrawal penalty on the amount owed.
When you take out a 401 loan, you dont have to pay any type of application fee or origination fee, so it seems like a low-cost option. But again, you have to take into account the money youre losing by not having as much invested in your account.
A great way to analyze the numbers is to use a retirement calculator. You can get a general idea of how much earnings youll be sacrificing to get your loan funds right away, then determine if its worth it or not.
Repaying The 401 Loan
You have up to five years to repay a 401 loan. However, if the loan is taken to buy a principal place of residence, the repayment tenure may be up to 15 years.
The IRS wants you to repay the loan in substantially equal payments that include principal and interest and that are paid at least quarterly. Your plan may directly deduct the repayment amount from your payroll.
No early repayment penalty is applied.
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How Do You Borrow Against Your 401 Plan
Retirement accounts are designed for you to hold until you retire. Thats why its generally difficult to withdraw money from a retirement savings account before age 59 ½. Borrowing from your 401 may impact your investment performance and cause tax issues.
However, while your nest egg may be impacted, there are several ways to borrow against your 401 plan.
Making A 401 Withdrawal For A Home
Compared to a loan, a withdrawal seems like a much more straightforward way to get the money you need to buy a home. The money doesn’t have to be repaid and you’re not limited in the amount you can withdraw, which is the case with a 401 loan. Withdrawing from a 401 isn’t as easy as it seems, though.
The first thing to understand is that your employer may not even allow withdrawals from your 401 plan due to age. If they do allow employees to tap 401 funds early, you may have to prove that you’re experiencing a financial hardship before they’ll allow a withdrawal. Under the IRS rules, consumer purchases generally don’t fit the hardship guidelines.
You may be able to withdraw funds from a 401 plan that you’ve left behind at a previous employer and haven’t rolled over to your new 401. This, however, is where things can get tricky.
If you’re under age 59 1/2 and decide to cash out an old 401, you’ll owe both a 10% early withdrawal penalty on the amount withdrawn and ordinary income tax. Your plan custodian will withhold 20% of the amount withdrawn for taxes. If you withdraw $40,000, $8,000 would be set aside for taxes upfront, and you’d still owe another $4,000 as an early-withdrawal penalty.
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Our Take: Weigh The Pros And Cons
There are pros and cons to borrowing money from your 401k that you should carefully consider before taking any action. However, as fiduciaries , we would generally advise against taking a loan out against your 401k it is usually just too costly, as missing out on compounding interest can make a much bigger dent in your retirement savings than you might imagine.
But everyones situation is unique, so your financial advisor can help you decide what will work best for your specific circumstances.
Need to talk to someone about a 401k loan or other financial concerns? to see the wealth management services we offer here at Personal Capital.
Personal Capital Advisors Corporation is an investment advisor registered with the Securities and Exchange Commission . Any reference to the advisory services refers to Personal Capital Advisors Corporation. Registration does not imply a certain level of skill or training nor does it imply endorsement by the SEC. Past performance is not a guarantee of future return, nor is it necessarily indicative of future performance. Keep in mind investing involves risk.
The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.
The Secure Act Of 2019
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The Setting Every Community Up for Retirement Enhancement Act of 2019 made it so you can withdraw up to $5,000 penalty-free from your 401 following the birth or adoption of a child.
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The SECURE Act also made it possible to withdraw up to $10,000 in the lifetime of each beneficiary to pay off costs of apprenticeship and student loan payments.
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withdrawals here.)
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When Can You Take Out A Loan From 401
When you find it a challenge to find liquid cash for serious short-term financial need, getting a loan from your 401 plan is a good idea.
Your serious liquidity need could be a one-time demand for funds or a lump sum cash payment required to tide over a crisis situation, like the coronavirus outbreak that has disrupted your regular income flow.
How Do 401 Loans Work
When individuals are in a tight spot financially, they often turn to 401 loans. The interest rate for the 401 loans is usually a point or two higher than the prime rate, but they can vary. By law, individuals are allowed to borrow the lesser of $50,000 or 50% of the total amount of the 401.
Also Check: What To Do With Your 401k When You Retire
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.
Use For Emergencies Only
If you face a serious financial need, borrowing money from your 401k plan may make sense, as it can be easy to get. But consider it only after you’ve exhausted your cash savings accounts. Keep in mind if you leave your employer for any reason, a 401k loan can create a major financial burden.
The information in this article was obtained from various sources not associated with State Farm® . While we believe it to be reliable and accurate, we do not warrant the accuracy or reliability of the information. State Farm is not responsible for, and does not endorse or approve, either implicitly or explicitly, the content of any third party sites that might be hyperlinked from this page. The information is not intended to replace manuals, instructions or information provided by a manufacturer or the advice of a qualified professional, or to affect coverage under any applicable insurance policy. These suggestions are not a complete list of every loss control measure. State Farm makes no guarantees of results from use of this information.
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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.
Before Taking A Hardship Withdrawal
Many people do not know that 401 money is shielded from creditors and protected from bankruptcy. If you are experiencing financial hardship and think that you may end up filing bankruptcy, do not cash out your 401 plan. Your creditors cannot take your 401 plan money.
It may be better to borrow money rather than take a 401 hardship withdrawal. Too many people cash out of a 401 plan or take a hardship withdrawal to pay medical expenses when their 401 money would be protected. Try working out a payment plan before you touch your 401 money.
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