If You Default On Your 401 Loan You’ll Owe A Penalty
If you do not pay your 401 loan back as required, the defaulted loan is considered a withdrawal or distribution and thus is subject to a 10% penalty applicable to early withdrawals made before age 59 1/2. That’s potentially a huge cost, especially when you also consider the loss of the potential gains your money would have made had you left it invested.
How To Borrow From Your 401k
Since the exact stipulations for your 401k plan loan will vary from employer to employer, youre going to want to call the plan provider and ask them these basic questions:
- How much interest do I have to pay? As said before, the interest amount will vary from provider to provider. Make sure that the interest along with the principal wont dip into your living expenses.
- Can I pay back through payroll deductions? Most plan providers will allow you to automatically deduct the amount you borrowed from your paycheck.
- Can I continue to invest while my money is borrowed? Some providers wont allow you to invest into your 401k until youre finished paying off what you borrowed which might affect your decision to do so.
- What happens if I leave my employer before the loan is paid? Very important question. Typically, youre on the hook for the rest of the loan balance within 60 days of leaving your job.
Once you have the questions answered and youre sure that you want to take a loan from your 401k, applying is pretty straightforward.
Youll likely be able to do it online via your 401k plan providers website or your companys benefits portal. If this isnt the case, you might have to contact your companys human resources department where theyll take care of it for you, or youll have to fill out some paperwork.
There are no credit checks and no crazy bureaucratic paperwork you need to fill out. You just need to have the money to borrow.
Should You Borrow From 401
Your 401 may be a good place to tap into when you need short-term liquidity. However, before tapping into your retirement money, you should explore other sources of cash available.
If borrowing from your 401 is the only option you have, you should understand the loan terms, and have a plan on how you will repay the loan. Using a 401 loan for the right short-term reasons can be the most convenient and lowest-cost of cash available.
Plan to make 401 loan payments ahead of schedule or make a lump sum payment to pay off the loan. The sooner you pay off the loan, the quicker you can return your money to generate returns while avoiding derailing your retirement progress.
How Do You Repay
Since youre borrowing from your 401 plan, you have to repay the loan. This is typically done by taking a portion of each paycheck and applying it toward your loan. In most cases, you can borrow for a term of up to five years, but longer-term loans may be allowed if youll use the money to buy your home. Again, borrowing is risky, and longer-term loans are riskier than shorter-term loans .
When you repay money that youve borrowed from your 401 plan, you dont get any tax benefits. That money is treated as normal taxable income to you, so it wont be like any pre-tax contributions that youve been making to the plan. You can still contribute to the plan with pre-tax dollars contributions if your plan allows) but you dont get to double-dip and get a tax break on loan repayments. Remember: You werent taxed on the money you received when you took the loan.
If you leave your job before you repay the loan, you should have an opportunity to repay any money you borrowed from the 401. But thats not always easy. You probably took the loan because you needed cash, and its therefore unlikely that you have a lot of extra money sitting around. Try to repay if possible, otherwise, you may face income taxes and tax penalties as described below. If youve been recruited to a new job, you might be able to get some help from your new employer .
When To Borrow From Your 401
Only borrow from your 401 when no other reasonable loan rates are available and only if the situation is dire.
Vacations are ruled out. So are 50-inch 4K TVs, shopping sprees and any form of consumerism that might be considered excessive. There are, however, emergencies or dead-end scenarios when a 401 loan may be your best or only option.
If youre suffering a medical setback and need cash fast, your 401 may be a good place to look. You may even qualify for a hardship withdrawal. In this case you wont have to pay the loan back, but youll still have to pay income taxes, plus the 10% early withdrawal fee.
The qualifications for hardship withdrawal differ from plan to plan. Check with your employer to see what yours may cover.
If youre looking at your 401 as a way out of debt, youre looking in the wrong direction. Debt is often the result of undisciplined spending or an unforeseen emergency like job loss or medical setback. Its rarely a one-time purchase that sends the consumer into financial despair.
Also Check: Is Rolling Over 401k To Ira Taxable
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:
Do Lenders Look At 401k
Despite the fact that if you withdraw 401k for house loan is a new monthly obligation, lenders dont count that obligation against you when analyzing your financial statements and debt-to-income ratio because the payment is not seen the same way as another regular loan. This is just like a car payment or student loan payment! Therefore, if your debt-to-income ratio is already high, you dont need to worry that your 401k home down payment will push you over the edge, nor will it downgrade your credit score.
However, the lender will deduct the available balance of your 401k loan by the amount of money you borrowed. Therefore, you might need to think twice before borrowing from your retirement savings if you are short on cash reserves. Some loan types require two months of housing payment reserves after closing.
Recommended Reading: How To Start Withdrawing From 401k
How Much Can I Borrow From My 401
The maximum anyone can borrow is $50,000. Even if you have a $1 million in your account, $50,000 is the most you can borrow under federal guidelines. If you have less than $100,000 in your account, you only can borrow as much as half your balance so if you have $84,000 in your account, you can borrow no more than $42,000. Some plans offer an option that allows you to borrow as much as $10,000 even if your account has less than $20,000 vested. Again, you need to read your plans rules or talk to your employer or plan administrator to learn more.
How Long Do You Have To Repay The Loan
Generally, 401 loans have a repayment period of five years. However, you may be allowed a longer repayment period of up to 15 years if you are using the loan to buy your primary residence. You must make loan payments at least once every quarter.
You may be required to make loan payments through automatic payroll deductions. Sometimes, an employee may elect to repay the loan through a check, but subject to the plan administrator’s approval. If the request is granted, you will be responsible for making loan payments on time.
Don’t Miss: How Do You Transfer 401k
The Downsides Of Borrowing From Your 401k
As we mentioned in the previous section, theres a chance that you lose money on the compounding gains even with your repayment if your investment gains are more than your interest.
Lets take a look at a simplified example:
Imagine there are two investors: Derek and Cindy.
Both contribute about $5,000 / year to their 401k, which experiences 8% interest growth each year.
However, in the 10th year of investing, Derek decides to borrow $50,000 for a new home. How much do you think he slowed down his savings?
Derek by retirement age: $793,185.99.
Cindy by retirement age: $1,296,318.82
Dereks going to be behind Cindy by $503,132.83 because he borrowed from his 401k!
Guess what? If Derek quit or was fired from his job, hed be expected to pay back the entire loan within 60 days.
And if you default on the 401k loan for any reason, the loan will be subject to income tax as well as a 10% penalty from the federal government if youre under the age of 59 ½.
For example, if you borrowed $50,000 from your 401k and were only able to pay off $20,000 before you were let go from your job and forced to default on your loan, youd be taxed on the entire $30,000 you owe AND be forced to pay a fee of $3,000 .
On top of all that, the loan payments you make are made with after-tax money. So it wont make the same amount of money when all is said and done.
With the penalties and potential for lost gains, borrowing from your 401k just isnt worth it most of the time.
Benefits Of Borrowing From Your 401k To Buy A Home
The great thing about 401k loans is that they dont count towards your debt-to-income ratio. Using a 401k loan to finance your down payment can put you in a more favorable position for financing your mortgage. And, these loans are not reported to the credit bureaus, so they dont impact your credit score. It can also be beneficial to borrow from your 401k as a first time home buyer in order to make a higher down payment, especially in a competitive housing market. That said, you should consider the monthly payments on your 401k loan along with your monthly mortgage payment to ensure that these payments are within your budget.
Also Check: Can You Keep Your 401k In A Chapter 7
What Is A 401 Loan
A 401 loan is a loan you take out from your own 401 account. They work like normal loansyou pay origination fees and interestonly youre borrowing money from yourself. According to Vanguard, 78% of 401 plans permit participants to take out 401 loans, and about 13% of plan participants have an outstanding 401 loan.
If you need money, you might consider taking a loan from your 401 if:
You want a lower interest rate. 401 loans still charge interest. But the amount you pay may be less than on a loan you take out with someone else. 401 loan interest rates are based on the prime rate, an interest rate adapted from Federal Reserve loaning guidelines. 401 loans will normally be a percentage point or two above this rate, which may be lower than the rate you could get at a bank.
Youd prefer to pay interest to yourself. No one likes paying banks and credit card companies interest. While youre still on the hook for interest payments with a 401 loan, you get to pay it back to yourself instead of someone else.
You want looser credit requirements. If your credit score prevents you from getting the best rates on loans, you may opt for a 401 loan. Depending on your employer, you may not even need a credit check to borrow from your 401.
You might want to avoid a 401 loan if:
When You Have A Comfortable Retirement Cushion
If youve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If thats the case, and your job is stable, taking a loan from your 401 may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for exampleor, if you have a child in college, as a less expensive alternative to student loans.
Don’t Miss: Do You Get Your 401k When You Quit
Can You Use Your 401 To Buy A House
Retirement accounts are just that: money thats being set aside for you to use in your golden years. And if youve been carefully saving, you might be wondering if its OK to tap those funds to use for something right now, like a home purchase, given that its an investment in its own right.
One of the most common types of retirement plans is the 401, which is often offered by companies to their workers. It provides an easy way to earmark some of your salary for retirement savings, along with the tax benefits that a 401 brings. Youll be setting aside money without paying taxes right now and then will pay the taxes when you withdraw it, which ideally will be when youre in a lower tax bracket than youre in now. In many cases, companies also match up to part of your personal savings, which is another reason that 401 accounts are so popular, since thats essentially free money.
But those funds have been set aside specifically for your retirement savings, which means that if your plan allows you to withdraw it earlier, youll pay a penalty, along with the taxes you owe given your current tax bracket. Theres usually the potential to borrow from it, though, which may be a better option.
So, while you can use your 401 for a first-time home purchase in most cases, the question is whether you should.
Is A Deemed Distribution Treated Like An Actual Distribution For All Purposes
No, a deemed distribution is treated as an actual distribution for purposes of determining the tax on the distribution, including any early distribution tax. A deemed distribution is not treated as an actual distribution for purposes of determining whether a plan satisfies the restrictions on in-service distributions applicable to certain plans. In addition, a deemed distribution is not eligible to be rolled over into an eligible retirement plan. -1, Q& A-11 and -12)
Also Check: How To Find Previous Employer’s 401k
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.
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.
You May Like: Is An Ira Better Than 401k