Borrowing Against A : What To Consider
Sarah Brodsky, March 2017
Ideally, money that you put into a 401 is supposed to stay there until you retire. The IRS imposes a number of restrictions and penalties on early distributions that are meant to dissuade people from pulling their funds out early. Still, the government recognizes that there are times when it’s appropriate to tap into that money, and it allows you to borrow from a 401 with some limitations.
Avoid 401k Debit Cards At All Costs
Many consumers are looking for easy access to additional funds since the financial crisis and recession. Even though the recession is technically over, many are still feeling the pinch. As a result, there has been a bigger move toward tapping retirement accounts as emergency funds.
One of the ways that it has been made easier to get a 401 loan is by adding a debit card to the account.
Why Do People Get 401 Loans
As long as a plan allows it, participants generally can borrow from their 401 for any reason. Some plans may only allow loans for specific reasons, so be sure to check your plans rules before trying to borrow.
Since youre borrowing your own money, and no credit check is involved, it may be easier to get approved for a 401 loan as long as you meet the plans requirements for borrowing. In some cases, a requirement may be getting approval from your spouse , because your spouse may be entitled to half of your retirement assets if you divorce.
Here are some potential uses for a 401 loan.
- Paying household bills and expenses
- Funding a down payment on a house
- Paying off high-interest debt
- Paying back taxes, or money owed to the IRS
- Funding necessary home repairs
- Paying education expenses
But that doesnt mean 401 loans are always a good idea. In fact, there are some major risks that come with borrowing from your retirement savings. Here are two.
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K Loan Repayment After Leaving A Job
The biggest fear that surrounds borrowing from a 401k is what will happen if you leave the job either voluntarily or involuntarily. Before the Tax Cuts and Jobs Act, loan repayments must have been met within 60 days.
Nowadays you have until your tax returns due date for the year you left your job.
For example, if you left your job in 2020, youd have until April 15, 2021, to repay your loan .
Any outstanding loan balance not repaid on time will be seen as an early withdrawal and subject to an early withdrawal penalty.
This understandably freaks people out. Ideally, you wont borrow against your 401k if you feel that you are in danger of losing your job or you plan to leave shortly. If your job is stable, this fear is mostly unfounded.
Of course, all of us are expendable. What if you do lose your job and have to pay the money back?
Well, we dont have debtors prisoners anymore , so its not like youll be locked up. What will happen is that the IRS will classify the remaining balance as an early withdrawal, hit you with a 10% penalty on that amount, and require you pay taxes on the distribution.
The Downside To 401 Loans
The biggest drawback to a 401 loan is that the money you borrow doesnt earn an investment return, and this can cost you.
If you take a five-year loan at an interest rate of 5.75% , your loan balance will be more than 30% less than if youd left that amount invested and growing at 5%.1 There are other drawbacks:
- If you dont repay your loan, it goes into default. A defaulted loan becomes a withdrawal and may be subject to taxes and penalties. It also permanently drains your retirement plan.
- Loan fees are paid to the service provider. Fees vary, but they’re usually in the range of $50 to $75 and can be ongoing.
- You normally have to pay back your loan immediately if you leave your job. If youre considering a job change, youll need to make plans to repay your loan so that you dont default on it.
- 401 loan interest is double taxed. You pay loan interest into your 401 with after-tax dollars, and youre taxed on those same dollars again in retirement.
Loans can be habit forming.Statistically, people whove borrowed before are more likely to borrow in the future than people who havent borrowed at all.
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Why Take A 401 Loan
When you need cash and are having trouble getting approved for a loan, taking out a 401 loan may seem like a good idea. These loans have fairly generous repayment terms and are not contingent upon credit approval. You can apply for up to $50,000 without worrying if a bank is going to stick you with a high interest rate or decline your application.
Although a 401 loan is not ideal compared to some alternatives, it is better than others. These are some common reasons when a 401 loan makes sense:
- Need the money for the short term. If you can repay the loan in less than a year, it makes sense to avoid loan fees or higher interest rates of some loan options.
- Avoiding a payday loan. When a payday loan is your only other alternative, a 401 loan helps you avoid predatory fees and interest rates charged by payday lenders.
- Your credit score is bad. Some people have such a high debt that their credit scores are trashed. Taking out a 401 loan allows you to pay down your debt and reduce your credit utilization and improve your credit score. Once your score is higher, you might be able to qualify for better rates and terms from a traditional lender to repay your 401 loan.
- Down payment for a home. Normal 401 loans must be repaid within five years. But, when you borrow from your 401 to buy a home, you can stretch the payments out for up to 25 years.
Who Should Withdraw From Their 401 Early
Just because you qualify for a hardship-related withdrawal doesnt mean you should take one without weighing all your other options.
The experts we spoke with were all in agreement that withdrawing from your 401 shouldnt be your first move. However, they also indicated that if youre truly in need, then you should take advantage of the CARES Acts allowances.
It should be a last resort option. People shouldnt get carried away and start using their 401 assets just because they can, Pfau says.
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How Long Does It Take To Get A 401k Loan
If you plan to borrow from your 401, you should know how long it takes to get the 401 loan. Find out the duration the direct deposit or mailed checks will take to arrive.
When a 401 loan is the only option you have, your 401 acts as a safety net, and you can borrow to pay medical expenses, prevent foreclosure, or even pay college expenses for your child or spouse. If you have an urgent need, knowing how long it takes to get the 401 loan funds can help you plan ahead.
Once you get approved for a 401 loan, it can take anywhere from a day if you sent an online loan application to several weeks if you sent a manual loan application. Online applications tend to be swift since loan processing is automated. However, manual applications may need to be signed by several people, which increases the loan processing time.
What Are Alternatives
Because withdrawing or borrowing from your 401 has drawbacks, it’s a good idea to look at other options and only use your retirement savings as a last resort.
A few possible alternatives to consider include:
- Using HSA savings, if it’s a qualified medical expense
- Tapping into emergency savings
- Transferring higher interest credit card balances to a new lower interest credit card
- Using other non-retirement savings, such as checking, savings, and brokerage accounts
- Using a home equity line of credit or a personal loan3
- Withdrawing from a Roth IRAthese withdrawals are usually tax- and penalty-free
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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.
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Reasons To Take Out A 401k Loan
So now youre wondering, under what circumstances can I take a loan from my 401k? The answer is many.
And in those situations there are several incentives to doing so.
Typically speaking, 401 loans work best for short-term needs, where you can repay the money quickly.
Some of the best reasons to take out a 401 loan include:
- Purchasing a home
- Pursuing higher education
- Financing a business or investment
In some cases, you might be eligible for a loan extension if you used the money as a down payment on a house.
Thats great, youre saying, but can I use my loan to help alleviate financial hardship?
You might be especially curious about this question if you owe money in back taxes to Uncle Sam.
In most cases, you can use the money however you want, including paying for taxes.
This can be an appealing option if the amount of interest youll pay is smaller than potential tax penalties.
However, some plans do place restrictions on how the money can be used. Before you take out a loan make sure you know if such restrictions exist and what they entail.
More importantly, be wary of potential downsides linked to borrowing money from your 401k.
Will Your Employer Know If You Take Out A 401 Loan
Yes, its likely your employer will know about any loan from their own sponsored plan. You may need to go through the human resources department to request the loan and youd pay it back through payroll deduction, which theyd also be aware of. Loans arent guaranteed to be approved either or your plan may not offer them at all. If youre concerned about a manager or executive finding out about the loan request, consider asking HR to keep your request confidential.
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What Is A 401 Debit Card
Many 401k providers have begun allowing account holders to apply for a 401 debit card. Your 401 debit card can be used to access money that you already have in your account. However, even though it is called a debit card, its really more like a line of credit.
When you use the 401 debit card, you end up paying fees and interest and making payments to repay the loan. Its true you are borrowing from yourself, but it can still result in lost opportunities. It reminds me more of the card I have to access my Preferred Line of Credit at the bank, or the card you can get to access a HELOC.
Its also important to note that you cant just access your entire nest egg with a 401 debit card. First of all, your employers plan has to offer the option of using a 40 debit card. Then you end up with a pre-approved amount that you can draw on. That money is moved to a money market account, and you withdraw from that account. Even though the money attached to your 401 debit card does earn a return in the money market account, it may not be as much as your other assets are earning in the main account.
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Better Options For Emergency Cash Than An Early 401 Withdrawal
It can be scary when suddenly you need emergency cash for medical expenses, or when you lose your job and just need to make ends meet.
The money squeeze can be quick and traumatic, especially in a more volatile economy.
Thats why information about an early 401 withdrawal is among the most frequently searched items on principal.com. Understandably so, in a world keen on saddling us with debt.
But the sad reality is that if you do it, you could be missing out on crucial long-term growth, says Stanley Poorman, a financial professional with Principal® who helps clients on household money matters.
The most severe impact of a 401 loan or withdrawal isnt the immediate penalties but how it interrupts the power of compound interest to grow your retirement savings.
In short, he says, You may be harming your ability to reach and get through retirement. More on that in a minute. First, lets cover your alternatives.
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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.