Repayment Terms On 401 Loans
- You must pay back your loan within five years. You can do so via automatic payroll deductions, the same way you fund your 401 in the first place. There is no penalty for paying off the loan sooner than that.
- You must pay interest on the loan, at a rate specified by your 401 fund administrator. Typically the rate is calculated by adding one or two percentage points to the current prime interest rate.
Taking Money Out Of A Retirement Account May Have Financial Penalties
There are different rules on early withdrawals depending on the type of account. The type of account you want to take money out of will determine the penalties.
You maybe able to withdraw funds from your 401 via a loan or hardship withdrawal, but there may be plan limitations on these withdrawals. Note loans must be repaid, and hardship withdrawals are subject to a 10% penalty and income tax. If you have a 401 plan from a previous employer you may be able to access that savings with less restrictions but early withdrawals before age 59 1/2 are subject to the same 10% penalty and income taxes.
Traditional IRAs are subject to similar penalties and taxes on distributions as the 401 is, but the exceptions are a little more relaxed. For example, first time home buyers can take out $10,000 from their Traditional IRA without paying the 10% fees. You do still need to pay income tax on this withdrawal though. The same applies for qualified education expenses and health insurance premiums while unemployedyou wont pay the 10% fee, but you will pay income taxes.
How Are Withdrawals Of Roth 401 Deferrals Taxed
Because Roth 401 deferrals are contributed to your account on an after-tax basis, they are never taxable upon withdrawal. Their earnings can also be withdrawn tax-free when theyre part of a qualified withdrawal. A qualified withdrawal is one that occurs 1) at least five years after the year you made your first Roth deferral and 2) after the date you:
- Attain age 59½
- Become disabled
If you withdraw Roth 401 deferrals as part of a non-qualified withdrawal, their earnings are taxable at applicable Federal and state rates and may be subject to the 10% premature withdrawal penalty.
Additional answers to Roth questions can be found in our Roth FAQ.
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What Are The Requirements For Repaying The Loan
Typically, you have to repay money you’ve borrowed from your 401 within five years by making regular payments of principal and interest at least quarterly, often through payroll deduction. However, if you use the funds to purchase a primary residence, you may have a much longer period of time to repay the loan.
Make sure you follow to the letter the repayment requirements for your loan. If you don’t repay the loan as required, the money you borrowed will be considered a taxable distribution. If you’re under age 59½, you’ll owe a 10 percent federal penalty tax, as well as regular income tax on the outstanding loan balance .
How To Make An Early Withdrawal From A 401
When you have determined your eligibility and the type of withdrawal you want to make, you will need to fill out the necessary paperwork and provide the requested documents. The paperwork and documents will vary depending on your employer and the reason for the withdrawal, but when all the paperwork has been submitted, you will receive a check for the requested funds, hopefully without having to pay the 10% penalty.
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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.
Move Your Money To Your New Employer’s Plan
If you have a new employer offering a retirement plan, you may be able to transfer your savings into it.
- Your savings stay invested with the same tax advantages
- You might be able to roll in savings from other retirement plans
- You can make ongoing contributions.
- The investment options depend on what the plan offers.
- You may be able to take out a plan loan, or withdraw money before retirement under certain circumstances
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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.
Keep Contributing To Your 401 And Other Retirement Accounts
Steadily contributing to your 401 is another way to protect it from future market volatility. Cutting back on your contributions during a downturn may cost you the opportunity to invest in assets at discount prices. Meanwhile, maintaining your 401 contributions during a period of growth when your investments have exceeded expectations is equally important. The temptation to scale back your contributions may creep in. However, staying the course can bolster your retirement savings and help you weather future volatility.
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Diversification And Asset Allocation
Allocating the right amount of money to a diverse array of assets is crucial to protecting your 401 from a stock market crash, while also maximizing returns. As an investor, you understand that stocks are inherently risky, and as a result, offer higher rewards than other assets. Bonds, on the other hand, are safer investments but usually produce lesser returns.
Having a diversified 401 of mutual funds that invest in stocks, bonds and even cash can help protect your retirement savings in the event of an economic downturn. How much you choose to allocate to different investments depends in part on how close you are to retirement. The further you are from retiring, the more time you have to recover from market downturns and full-fledged crashes.
Therefore, workers in their 20s would likely want a portfolio more heavily weighted in stocks. While other coworkers nearing retirement age would probably have a more even distribution between lower-risk stocks and bonds to limit exposure to a market drop.
But how much of your portfolio should be invested in stocks vs. bonds? A general rule of thumb is to subtract your age from 110. The result is the percentage of your retirement portfolio that should be invested in stocks. Investors who are more risk-tolerant will subtract their age from 120, while those who are more risk-averse will do the same from 100.
What If You Only Need The Money Short Term
Although there are other qualifying exceptions to withdraw IRA or 401k assets penalty-free, those listed above are the major ones. But suppose youre not interested in paying any taxes at all. You can still use your 401k to borrow money via a loan. The interest goes to you, the loan isnt taxable, and it wouldnt show up on your credit report. Heres how it works.
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Making A Hardship Withdrawal
Depending on the terms of your plan, however, you may be eligible to take early distributions from your 401 without incurring a penalty, as long as you meet certain criteria. This type of penalty-free withdrawal is called a hardship distribution, and it requires that you have an immediate and heavy financial burden that you otherwise couldn’t afford to pay.
The practical necessity of the expense is taken into account, as are your other assets, such as savings or investment account balances and cash-value insurance policies, as well as the possible availability of other financing sources.
What qualifies as “hardship”? Certainly not discretionary expenses like buying a new boat or getting a nose job. Instead, think along the lines of the following:
- Essential medical expenses for treatment and care
- Home-buying expenses for a principal residence
- Up to 12 months worth of educational tuition and fees
- Expenses to prevent being foreclosed on or evicted
- Burial or funeral expenses
- Certain expenses to repair casualty losses to a principal residence
The home-buying expenses part is a bit of a gray area. But generally, it qualifies if the money is for a down payment or for closing costs.
Caveats To The 4% Rule
Several variables can make this rule of thumb either too conservative or too risky, and you might not be able to live on 4%-ish a year unless your account has a significantly large balance.
The first caveat you should consider when thinking about applying the 4% rule to your personal situation is that it calls for putting 50% each in stocks and bonds. You may not be comfortable putting that much of your retirement assets in equities, and you may want to keep at least a portion of your nest egg in cash or a money market fund.
You also might not expect to live for 30 years after retirement, either because you retired later than most people do or for some health-related reason. And you may not feel you need the almost 100% confidence level Bengen was seeking in his rule a confidence level of 75% to 90% that you won’t run out of money might be acceptable to you and may afford a more flexible withdrawal rate.
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Roll It Over To Your New Employer
If youve switched jobs, see if your new employer offers a 401, when you are eligible to participate, and if it allows rollovers. Many employers require new employees to put in a certain number of days of service before they can enroll in a retirement savings plan. Make sure that your new 401 account is active and ready to receive contributions before you roll over your old account.
Once you are enrolled in a plan with your new employer, its simple to roll over your old 401. You can elect to have the administrator of the old plan deposit the balance of your account directly into the new plan by simply filling out some paperwork. This is called a direct transfer, made from custodian to custodian, and it saves you any risk of owing taxes or missing a deadline.
Alternatively, you can elect to have the balance of your old account distributed to you in the form of a check, which is called an indirect rollover. You must deposit the funds into your new 401 within 60 days to avoid paying income tax on the entire balance and an additional 10% penalty for early withdrawal if youre younger than age 59½. A major drawback of an indirect rollover is that your old employer is required to withhold 20% of it for federal income tax purposesand possibly state taxes as well.
Never Pull Money From Your 401 Except In These 3 Cases
- Average account balances have hit a high of $92,500.
- If you leave your job, the loan may become due.
- Make sure you can handle the repayments.
Here’s a personal finance rule you can break with reservations: Taking a loan from your 401 plan.
Aside from your house, your workplace retirement plan likely makes up the largest chunk of your overall wealth. The average 401 balance in the fourth quarter of 2016 hit an all-time high of $92,500, according to data from Fidelity Investments.
In a perfect world, you’d want to let your account ride as long as it can, taking advantage of market cycles over time and steady deferrals from your pay each week.
However, certain emergencies and long-term planning goals call for the more drastic step of borrowing from your 401, as was the case for Greg Walton.
The 32-year-old IT support engineer at the Massachusetts Institute of Technology borrowed $7,000 from his 401 in order to pay off a student loan with a higher interest rate and which had gone into default at one point.
Walton is repaying the loan directly from his paycheck.
“Plan participants understand that the money is sacrosanct, but they may find themselves in a situation where the 401 is the largest source of capital they have,” said James A. Cox, financial advisor at Harris Financial Group in Richmond, Virginia.
Here’s how to borrow from your 401 without ending up with a big tax bill.
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Withdrawals From A 401
401 hardship withdrawals If you find yourself facing dire financial concerns and need cash urgently, your 401 plan may offer a hardship withdrawal option. Unlike a 401 loan, you wont have to repay the money you take out, but you will owe taxes and potentially a premature distribution penalty on the amount that you withdraw. In addition, IRS 401 hardship withdrawal rules state that you may not take out more money than what is needed to cover your hardship situation. In order to qualify for a 401 hardship withdrawal, your plan administrator must offer this option and you must be facing an immediate and heavy financial need. According to the IRS, approved 401 hardship withdrawal reasons include:
- Postsecondary tuition for you or your family
- Medical or funeral expenses for you or your family
- Certain costs related to buying, or repairing damage to, your primary residence
- Preventing your immediate eviction from or foreclosure of your primary residence
If you experience a financial hardship from a circumstance not on this list, you may still be able to qualify for a hardship withdrawal, so check with your plan administrator.
- In-service, non-hardship withdrawals
This type of withdrawal is only allowed under certain plans and is mainly used by those who would like to explore other investment options. Learn more about in-service distributions. An Ameriprise financial advisor can provide more detailed information on in-service 401 distributions.
What To Ask Yourself Before Making A Withdrawal From Your Retirement Account
There are many valid reasons for dipping into your retirement savings early. However, try to avoid the mindset that your retirement money is accessible. Retirement may feel like an intangible future event, but hopefully, it will be your reality some day. So before you take any money out, ask yourself: Do you actually need the money now?
Think of it this way: Rather than putting money away, you are actually paying it forward. If you are relatively early on in your career, your present self may be unattached and flexible. But your future self may be none of those things. Pay it forward. Do not allow lifestyle inflation to put your future self in a bind.
With all this talk of 10% penalties, and not touching the money until youre retired, we should point out that there is a solution if you feel the need to be able to access your retirement funds before you reach age 59 ½ without penalty.
Contribute to a Roth IRA, if you qualify for one.
Because contributions to Roth accounts are after tax, you are typically able to withdraw from one with fewer consequences. Keep in mind that there are income limits on contributing to Roth IRAs, and that you will still be taxed if you withdraw the funds early or before the account has aged five years, but some people find the ease of access comforting.
For some folks, however, a Roth-type account is not easily available or accessible to them.
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What Are The Penalty
The IRS permits withdrawals without a penalty for certain specific uses, including to cover college tuition and to pay the down payment on a first home. It terms these “exceptions,” but they also are exemptions from the penalty it imposes on most early withdrawals.
It also allows hardship withdrawals to cover an immediate and pressing need.
There is currently one more permissible hardship withdrawal, and that is for costs directly related to the COVID-19 pandemic.
You’ll still owe regular income taxes on the money withdrawn but you won’t get slapped with the 10% early withdrawal penalty.
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.
No minimum credit score is required.
The money isn’t counted as a debt on your credit report.
It may be cheaper than borrowing from a bank.
You won’t pay income tax or a penalty tax on the withdrawn amount.
You repay the loan with automatic paycheck deductions.
Not all employers permit loans from their plan.
There’s a limit on how much you can borrow.
You may lose investment gains from the money you withdrew.
You may feel tethered to your employer for longer than you want.
Your withdrawn money will no longer be protected in the event you go bankrupt.
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