What Is A 401 Loan
Most 401 plans allow participants to borrow their own money from the plan and repay the loan through automatic payroll deductions.
Unlike personal loans and home equity loans, 401 loans are usually easy to get. There’s no credit check, and applications are typically short. However, they’re like other types of debt in that you must pay interest on the amount you borrow. Your plan’s administrator determines the interest rate, but it must be similar to the rate you’d receive when borrowing money from a bank. The good news though is that you are paying interest to your own 401 account.
Typically, 401 loans must be repaid within five years. That repayment period can be extended if you use the loan to purchase a home.
Withdrawing From Your 401 Before Age 55
You have two options if you’re younger than age 55 and if you still work for the company that manages your 401 plan. This assumes that these options are made available by your employer. You can take a 401 loan if you need access to the money, or you can take a hardship withdrawal., but only from a current 401 account held by your employer. You can’t take loans out on older 401 accounts.
However, you can roll the funds over to an IRA or another employer’s 401 plan if you’re no longer employed by the company. But these plans must accept these types of rollovers.
Think twice about cashing out. You’ll lose valuable creditor protection that stays in place when you keep the funds in your 401 plan at work. You could also be subject to a tax penalty, depending on why you’re taking the money.
Those Who Can Stomach The Loss In Stock Value
Because a 401 is an investment account, you should also consider the trade-off of missing the market rebound if you withdraw funds right now. Any money that you borrow from your 401 now wont be there when the market turns around, Renfro says. This would compound the adverse effects of an early 401 withdrawal if you dont truly need one.
Echoing that, Levine says many 401 balances have been hit hard, and taking a loan while theyre down essentially locks in the losses.
Taking an early withdrawal from your 401 can have long-term adverse effects on your financial health. However, so can the ramifications of COVID-19, especially if youve been particularly affected by the disease. The CARES Act gives options to those who need it most. Theres no right answer, but in times of uncertainty and struggle, those options can be a life raft.
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What Is A 401
The IRS and other government agencies can be confusing.
And for something as important as retirement plans, it’s imperative that you understand your options.
A 401 plan is a retirement saving and investing plan that many companies offer their employees.
The plan awards employees with tax breaks on any money they contribute.
There are a few different plans though, so it’s important to check with the IRS website and your employer to see which one works best for you.
Substantially Equal Periodic Payment
I will now tackle a second method that enables you to pull money from your retirement funds early without paying the 10% penalty. The second method is called Rule 72 Substantially Equal Period Payments
This method is calculation-intensive and I recommend checking with a tax professional if this is a method you plan to implement. In this post, I will highlight the following:
- How Rule 72, also known as SEPP, works from a high level
- The rules for how many years you need to withdraw from your IRA
- The three methods for calculating the amount you can withdraw each year
- An example from the Mad Fientist comparing SEPP versus other withdrawal methods
- Cautions to be aware of regarding SEPP
- My take on SEPP and if I plan to implement it
How Does Rule 72 Work?
The rule enables you to withdraw funds from your IRA before you turn 59 1/2 without paying the 10% early withdrawal penalty. Before I dig into this in detail, I recommend checking with a tax professional if this is something you want to do.
If you make a mistake in calculating how much you can withdraw each year, you will have to pay taxes and potentially penalties on each distribution youve taken.
Another caution with SEPP is the length of how long you have to withdraw money. The SEPP plan requires you to withdraw money each year until you turn 59 1/2 or for at least five years, whichever is longer. You can keep withdrawing indefinitely if you choose to.
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Only Pay The Penalty If You Have To
The above are some creative ways to access your retirement savings before age 59 1/2. While you can always pay the penalty and withdraw funds directly if you absolutely have to, using proper planning will ensure you can keep more of your money. If you plan things right, you may be able to retire earlier than you thought.
What Are The Consequences Of Taking A Hardship Distribution
Whether youre a Millennial or Baby Boomer, a hardship withdrawal could have a significant impact on your retirement outcome. As a Baby Boomer, your years of catching up will be shorter. In some cases, you may never entirely catch up to where you once were prior to the withdrawal. It could also mean you may need to postpone your retirement until you are financially more stable, dramatically setting you back on your retirement goals.
As a Millennial, things arent quite as bleak. While a hardship disbursement will certainly set you back, you will have many more years in the workplace to make up the difference. However, they are still costly in the short term when you pay taxes, and participants that are not 59 ½ or older may be subject to a 10 percent penalty tax.
Heres the bottom line: the decision to take a hardship distribution is truly a personal one and is often surrounded by extenuating circumstances. Because of the impact on funds for retirement, hardship distributions should be your absolute last resort for withdrawing funds from your 401 retirement fund.
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What You Should Know About Withdrawing Retirement Funds Early
Is your retirement money only for retirement? Ideally, yes. But its your money, so the decision of what to do with is ultimately yours. During financially challenging times, its easy to understand the temptation to tap into retirement funds earlier than planned. But heres what you should know before you consider accessing retirement savings early.
What Is A Hardship Withdrawal
Another option in addition to the ones I describe below is taking a hardship withdrawal. According to the IRS, some retirement account types may allow you to make a withdrawal without the early withdrawal penalty but only if you have an immediate and heavy financial need. You will still pay taxes.
The hardship withdrawal is limited to the amount of money necessary for that hardship. So the hardship withdrawal is not a helpful early withdrawal penalty exception for a planned early retirement.
Heres a quick overview of different investment account types. There are some exceptions for each and rules for hardships, disabilities, and contribution limit rules. So check with a tax professional before making any major moves.
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What Are The Penalties For Withdrawing From My 401 Before Age 59
Unless you fall into one of the special exemption categories, you will pay a penalty of 10% of the amount of funds you withdraw. This can get quite pricey and really cut into your retirement savings. If you must make a withdrawal before reaching retirement age, then make sure you check the list of exemptions to the penalty. If you can qualify under one of the exemptions, then you will not be forced to pay this extra penalty.
Withdrawing Money Early From Your 401
The method and process of withdrawing money from your 401 will depend on your employer, and which type of withdrawal you choose. As noted above, the decision to remove funds early from a retirement plan should not be made lightly, as it can come with financial penalties attached. However, should you wish to proceed, the process is as follows.
Step 1: Check with your human resources department to see if the option to withdraw funds early is available. Not every employer allows you to cash in a 401 before retirement. If they do, be sure to check the fine print contained in plan documents to determine what type of withdrawals are available, and which you are eligible for.
Step 2: Contact your 401 plan provider and request that they send you the information and paperwork needed to cash out your plan, which should be promptly completed. Select providers may be able to facilitate these requests online or via phone as well.
Step 3: Obtain any necessary signatures from plan administrators or HR representatives at your former employer affirming that you have filed the necessary paperwork, executed the option to cash in your 401 early, and are authorized to proceed with doing so. Note that depending on the size of the company, this may take some time, and you may need to follow up directly with corporate representatives or plan administrators at regular intervals.
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Impact Of A 401 Loan Vs Hardship Withdrawal
A 401participant with a $38,000 account balance who borrows $15,000 will have $23,000 left in their account. If that same participant takes a hardship withdrawal for $15,000 instead, they would have to take out $23,810 to cover taxes and penalties, leaving only $14,190 in their account, according to a scenario developed by 401 plan sponsor Fidelity. Also, due to the time value of money and the loss of compounding opportunities, taking out $23,810 now could result in tens of thousands less at retirement, maybe even hundreds of thousands, depending on how long you could let the money compound.
Substantially Equal Period Payments
Substantially Equal Period Payments might be a good option if you need to withdraw money for a long term need. These payments must last a minimum of 5 years or until you reach the normal 401k withdrawal age of 59 1/2, whichever is shorter. For this reason, this is not a good option if you have a short term need like a sudden unexpected expense. You cannot withdraw funds under this method if you still work for the employer through which you have the 401. To calculate the amount of these payments, the IRS recognizes three acceptable methods.
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How Much Tax Do I Pay On An Early 401 Withdrawal
The money will be taxed as regular income. That’s between 10% and 37% depending on your total taxable income.
In most cases, that money will be due for the tax year in which you take the distribution.
The exception is for withdrawals taken for expenses related to the coronavirus pandemic. In response to the coronavirus pandemic, account owners have been given three years to pay the taxes they owe on distributions taken for economic hardships related to COVID-19.
Whats The Difference Between A Withdrawal And A 401 Loan
With a 401 loan, you must repay the money back into your account over a period of time. With a standard withdrawal, there are no repayment requirements. You will be charged interest on the loan, although you are technically paying the interest back to yourself. The money goes back into your 401 account, and you usually can spread the payments out up to 5 years. If you are using the money for a down payment on a home, you can even spread them over 15 years. A loan is usually a much better option than a withdrawal because at least you will be replacing the money. However, not all plans offer 401 loans, so that might not be an option for you.
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Taking 401 Distributions In Retirement
The 401 withdrawal rules require you to begin depleting your 401 savings when you reach age 72.
At this point, you must take a required minimum distribution each year until your account is depleted. If you are still working for the employer beyond age 72, you may be able to delay required minimum distribution until you stop working if your plan allows this delay. The delay option is not available to you if you own 5% or more of the business.
You have until April 1 of the year after you turn 72 to take your first required minimum distribution. After that, you must take a minimum amount by December 31 each year. Your 401 plan administrator will tell you how much you are required to take each year.
The amount is based on your life expectancy and your account balance. If you dont take your required minimum distribution each year, you will have to pay a tax of 50% of the amount that should have been taken but was not. If you participate in more than one employer plan, you must take a required minimum distribution from each plan.
When To Start Your Retirement Pension
The standard age to start the pension is 65. However, you can start receiving it as early as age 60 or as late as age 70.
If you start receiving your pension earlier, the monthly amount youll receive will be smaller. If you decide to start later, youll receive a larger monthly amount.
Theres no benefit to wait after age 70 to start receiving the pension. The maximum monthly amount you can receive is reached when you turn 70.
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What Type Of Situation Qualifies As A Hardship
The following limited number of situations rise to the level of hardship, as defined by Congress:
- Unreimbursed medical expenses for you, your spouse or dependents
- Payments necessary to prevent eviction from your home or foreclosure on a mortgage of principal residence.
- Funeral or burial expenses for a parent, spouse, child or other dependent
- Purchase of a principal residence or to pay for certain expenses for the repair of damage to a principal residence
- Payment of college tuition and related educational costs for the next 12 months for you, your spouse, dependents or non-dependent children
Your plan may or may not limit withdrawals to the employee contributions only. Some plans exclude income earned and or employer matching contributions from being part of a hardship withdrawal.
In addition, IRS rules state that you can only withdraw what you need to cover your hardship situation, though the total amount requested may include any amounts necessary to pay federal, state or local income taxes or penalties reasonably anticipated to result from the distribution.
A 401 plan even if it allows for hardship withdrawals can require that the employee exhaust all other financial resources, including the availability of 401 loans, before permitting a hardship withdrawal, says Paul Porretta, a compensation and benefits attorney at Troutman Pepper in New York.
An Early Withdrawal From Your : Understanding The Consequences
OVERVIEW
Cashing out or taking a loan on your 401 are two viable options if you’re in need of funds. But, before you do so, here’s a few things to know about the possible impacts on your taxes of an early withdrawal from your 401.
For information on the third coronavirus relief package, please visit our American Rescue Plan: What Does it Mean for You and a Third Stimulus Check blog post.
If you need money but are trying to avoid high-interest credit cards or loans, an early withdrawal from your 401 plan is a possibility. However, before you consider this option, be forewarned that there are often tax consequences for doing so.
If you understand the impact it will have on your finances and would like to continue with an early withdrawal, there are two ways to go about it cashing out or taking a loan. But how do you know which is right for you? And what are the tax consequences you should be expecting?
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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 you’re under 59-1/2, keep in mind that an early withdrawal from your 401 will cost you dearly. You’re robbing your future piggy bank to solve problems in the present.
You’ll miss the compounded earnings you’d otherwise receive, you’ll likely get stuck with early withdrawal penalties, and you’ll 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.
Hardship withdrawals
You are allowed to make withdrawals, for example, for certain qualified hardships — though you’ll probably still face a 10% early withdrawal penalty if you’re 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 aren’t reimbursed by your insurer.
Loans
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.
