Drawbacks To 401 Loans
Assuming the loan and repayment process goes perfectly smoothly, there are several major reasons you should think twice before borrowing from your 401 fund:
- A 401 loan uses money that should be invested and helping accumulate wealth for your retirement. The funds you pull out of your 401 cannot gain investment value, and the interest payments you’re making to yourself are unlikely to come close to matching the gains you’d make in a moderately successful stock or index fund. contribution or invest elsewhere.)
- For most borrowers, retirement savings get put on hold until the 401 loan is repaid. Payroll deductions for 401 loan repayment typically eliminate or greatly reduce 401 payments for the five years it takes to pay off the loan. Losing five or so years of retirement savings, and likely forfeiting some or all of your employer’s matching contributions to your 401 in the process, is potentially a huge setback in your retirement savings process. The goal with 401 plans, as with all long-term savings programs, is to stash funds in small, steady amounts over long periods of time, and let money accumulate through the power of compound growth and reinvestment. A 401 loan disrupts that process in a major way, and most funds can never fully recover.
If your 401 loan process doesn’t go smoothly, you could face even worse consequences:
Consider The Impact On Your Retirement Savings
Dont forget that a 401 loan may give you access to ready cash, but its actually diminishing your retirement savings. First, you may have to sell stocks or bonds at an unfavorable price to free up the cash for the loan. In addition, youre losing the potential for tax-deferred growth of your savings.
Also think about whether youll be able to contribute to your 401 while you are paying back the loan. A lot of people cant, possibly derailing their savings even more.
How Do You Prove Need For 401k Hardship Withdrawal
Each plan administrator can specify what documentation is required for proof of the financial need for a hardship withdrawal.
If the money is used to prevent home foreclosure, the administrator may require documentation from the mortgage company that the home is about to enter foreclosure, for example.
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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.
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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Do Lenders Look At 401k
The mortgage lender will want to see complete documentation of the 401k loan including loan terms and the loan amount. The lender will also want proof the funds were transferred into one of your personal checking or savings accounts so that its readily available when you are ready to close the mortgage loan.
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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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.
Loan Vs Hardship Withdrawal
If you are experiencing a financial hardship, you might be eyeing your 401 as a source of funds. The IRS rules permit 401 plans to approve hardship withdrawals. Some hardship distributions are not subject to the 10 percent early withdrawal penalty, including ones made for medical expenses, permanent disability, IRS levy, qualified domestic relations order and certain other circumstances. If you take a hardship withdrawal for any other reason, you face the 10 percent penalty tax.
Should a hardship suddenly arise, you might be undecided as to whether to take a 401 loan or a hardship withdrawal. However, the IRS has simplified the decision: You must take a 401 loan, if available, before you take a hardship distribution, unless the loan would prohibit you from retrieving other funds required to address the hardship. This stems from the general rule that you, within reason, tap all other sources of funds before taking a 401 hardship distribution.
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Dont Borrow From Your Retirement Plan Unless You Know These Things
When you need some fast cash, it can be tempting to look to your retirement plan. Youre allowed to borrow up to the lesser of $50,000 or 50 percent of your vested account balance, and while you will have to pay interest, that money will go toward your retirement instead of into a creditors pocket. It seems like a win-win, but there are some drawbacks to this approach that you should know before you use it. Heres a closer look at the most important things to keep in mind before borrowing from your retirement plan.
1. You could be taxed on the money
You typically have five years to pay back the amount that you borrowed, plus interest, though the repayment period may be longer if you use the money for a down payment on a home. If you cant pay back the full amount by the end of this period, the outstanding balance will be considered a distribution.
The distribution will be subject to income tax, which for most people will be either 12 percent or 22 percent in 2021. If youre on the bubble between two tax brackets, its possible that this distribution could push you over into the higher bracket, requiring you to pay even more in income tax than you had originally anticipated. And if that isnt bad enough, individuals under age 59 1/2 must also pay a 10 percent early withdrawal penalty.
2. You have to pay the loan back when you leave your job
3. Youll hurt your retirement savings
Alternatives to borrowing from your retirement plan
Loans Treated As Distributions
A 401 loan is treated as a deemed distribution to the extent that its balance has not been repaid by the deadline date, normally five years after the loan date. A deemed distribution is unlike a real distribution, as it is not a cash flow and cannot be rolled over into another account. Its sole purpose is to determine the amount of your tax and penalty exposure. Another circumstance that can trigger a deemed distribution is severance from your job. Your plan administrator can demand immediate repayment of the loan balance when you separate from your job. If you default on the loan, the balance will be treated as a deemed distribution. Some administrators might grant you a short grace period to repay the loan. If you can come up with some or all of the default amount within 60 days, you can contribute it to another 401 or an IRA, thereby reducing or eliminating the income tax triggered by the deemed distribution.
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When A 401 Loan Makes Sense
When you mustfind the cash for a serious short-term liquidity need, a loan from your 401 plan probably is one of the first places you should look. Let’s define short-term as being roughly a year or less. Let’s define “serious liquidity need” as a serious one-time demand for funds or a lump-sum cash payment.
Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America put it this way: “Lets face it, in the real world, sometimes people need money. Borrowing from your 401 can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loanor even a more reasonable personal loan. It will cost you less in the long run.”
Why is your 401 an attractive source for short-term loans? Because it can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan from your 401 is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your .
Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let’s dig a little deeper to explain why.
Is A 401k Loan Taxed Twice
Another myth is that when you borrow from your 401k, you are being taxed twice because youre paying the loan back with after-tax money.
But in truth, only the interest part of the repayment is treated that way. And being twice taxed on interest from this kind of loan is likely to cost less than what it would cost to borrow money in another way.
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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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Those Who Can Pay Themselves Back
Its not free money. You have to pay it back or risk getting hit with a hefty tax bill, says Jeff Levine, of Nerds Eye View, an online news source that caters to financial planners.
Someone who may not be able to pay it back should think a little harder about whether they should tap into their retirement assets or not, Pfau says.
Another thing to keep in mind is how close you are to retirement. For many people, this could force them into an early retirement. Borrowing from their 401 may just be a way of actually starting to take distributions for retirement earlier, Pfau says. You just have to recognize the trade-offs, like not having as much money for retirement down the road.
Alternatives To Borrowing From Retirement
Dipping into your 401 likely will lead to more troubles than its worth. There are other ways to get by while keeping your retirement funds intact. Learn more about prioritizing retirement vs paying off debt.
Here are some methods of dealing with a financial emergency:
- Home equity loan This is a good option for homeowners. It comes with a fixed interest rate that never changes. Right now, the average home equity loan rate is 7.74%.
- A personal loan Even if the interest is higher than youd like, its often better than interfering with the appreciation of your 401. If you have a credit score above 720, you may be able to find interest rates around 10%.
- Nonprofit credit counseling Maybe you dont feel comfortable putting your home up for collateral,or your credit is too low for a decent interest rate on a loan. Consider working with a nonprofit credit counseling agency. A credit counselor will take a look at your budget, walk you through your spending habits and help you establish a more manageable financial lifestyle.
A 401 is first and foremost a retirement account, not just a second savings or vacation fund. The tulips have been blooming in Holland for 400 years. Theyll be around down the line when youre financially ready and able.
In the meantime, keep making contributions to your 401. Let it sit. Watch it grow. Youll thank yourself later.
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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 .
