To Borrow Or Not To Borrow
You can borrow money from your retirement plan and pay the funds back with lower interest rates than other types of borrowing, such as a credit card. However, a loan may trigger fees, and you may be forced to pay back the entire amount you borrowed if you leave your job, voluntarily or not. You also need to find out how your employer structures these types of loans.
A Note About The Cares Act
Signed into law on March 27, 2020, the $2 trillion dollar Coronavirus Aid, Relief and Economic Security Act emergency stimulus bill was drafted to help those affected by the coronavirus pandemic. Under the act, 401 account owners can make a hardship withdrawal of up to $100,000 without paying the 10% penalty. The bill also grants the account holder 3 years to pay the income tax, rather than it being due within that same year.
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Weighing Pros And Cons
Before you determine whether to borrow from your 401 account, consider the following advantages and drawbacks to this decision.
On the plus side:
- You usually dont have to explain why you need the money or how you intend to spend it.
- You may qualify for a lower interest rate than you would at a bank or other lender, especially if you have a low credit score.
- The interest you repay is paid back into your account.
- Since youre borrowing rather than withdrawing money, no income tax or potential early withdrawal penalty is due.
On the negative side:
- The money you withdraw will not grow if it isnt invested.
- Repayments are made with after-tax dollars that will be taxed again when you eventually withdraw them from your account.
- The fees you pay to arrange the loan may be higher than on a conventional loan, depending on the way they are calculated.
- The interest is never deductible even if you use the money to buy or renovate your home.
CAUTION: Perhaps the biggest risk you run is leaving your job while you have an outstanding loan balance. If thats the case, youll probably have to repay the entire balance within 90 days of your departure. If you dont repay, youre in default, and the remaining loan balance is considered a withdrawal. Income taxes are due on the full amount. And if youre younger than 59½, you may owe the 10 percent early withdrawal penalty as well. If this should happen, you could find your retirement savings substantially drained.
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Common 401 Loan Questions
Can I borrow against my 401? Check with your plan administrator to find out if 401 loans are allowed under your employers plan rules. Keep in mind that even though youre borrowing your own retirement money, there are certain rules you must follow to avoid penalties and taxes.
How much can I borrow against my 401? You can borrow up to 50% of the vested value of your account, up to a maximum of $50,000 for individuals with $100,000 or more vested. If your account balance is less than $10,000, you will only be allowed to borrow up to $10,000.
How often can I borrow from my 401? Most employer 401 plans will only allow one loan at a time, and you must repay that loan before you can take out another one. Even if your 401 plan does allow multiple loans, the maximum loan allowances, noted above, still apply.
What are the rules for repaying my 401 loan? In order to be compliant with the 401 loan repayment rules, youll need to make regularly scheduled payments that include both principal and interest, and you must repay the loan within five years. If youre using your 401 loanto buy a primary residence for yourself, you may be able to extend the repayment period. What if I lose my job before I finish repaying the loan? If you leave or are terminated from your job before youve finished repaying the loan, you typically have 60 days to repay the outstanding loan amount.
Summary of loan allowances
Why Do People Get 401 Loans
As long as a plan allows it, participants generally can borrow from their 401 for any reason that they deem necessary. 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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If You Take A 401 Loan Youll Pay Interest To Yourself
When you borrow against your 401, you have to pay interest on your loan. The good news is that youll be paying that interest to yourself. Your plan administrator will determine the interest rate, which is usually based on the current prime rate.
The bad news is that you will pay interest on your 401 loan with after-tax dollars. When you take money out as a retiree, you are still taxed on the distributions at your ordinary income tax rate. This means the money is effectively taxed twice once when you earn it before using it to pay back your loan and then again when the withdrawal is made.
The interest you pay yourself is generally also below what you would earn if you had left your money invested.
How To Repay A 401k Loan
If you take out a loan from your 401k, you will have to repay the loan principal plus interest. The repayment schedule and interest rate will be determined when you take out the loan. You will typically have up to five years to repay a 401k loan, but some employers may require a shorter repayment period.
If you leave your job before the loan is repaid, you will generally have to repay the entire loan within 60 days. If you dont repay the loan, it will be treated as a distribution from your 401k account and will be subject to income taxes and, if you are under age 59 1/2, a 10% early withdrawal penalty.
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The Cares Act And 401 Loans
The Coronavirus Aid, Relief, and Economic Security Act, which became law on March 27, 2020, enables people who had taken out a 401 loan to delay for up to one year payments owed from that date through December 31, 2020. Interest would still accrue on your outstanding balance during the period of delayed payments.
Heres What To Do When Your 401 Is Losing Money
Generally, the best move to make when you see your 401 balance go down is to do nothing at all.
This advice generally echoes investment experts guidance when any of your investments are affected by market downturns. Investing is a long-term game you take the short-term dips in exchange for the potential long-term growth, which, history has shown us, is what happens. Though past performance does not predict future performance, historically, any short-term losses have typically been outweighed by larger long-term gains.
In the long run, stock prices are the worlds way of appraising the value of the underlying companies, Winsett explains. In the short term, prices can be chaotically random but over time, prices are firmly rooted in the real value of real companies whose products and services we use regularly, if not daily.
Making an impulsive move like panic selling your 401 investments or withdrawing early from your 401 would have serious consequences. If you sell only to later jump back in the market, you may time it incorrectly and miss out on an upswing, or big recovery gains. Staying invested means as the market recovers, so, too, does your account balance. Dipping into your 401 funds before reaching the age of 59½, meanwhile, entails a 10% early withdrawal penalty on top of it being taxed.
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Take A 401k Loan: What You Should Know
Borrowing against funds in your plan may be allowed. But is it ever a good idea?
After years of regular contributions, a 401 plan through your employer may become one of your largest financial assets. In some cases, your employer may also allow you to borrow against the funds in that plan, which may be another financial benefit to you.
As you continue to work and build for your retirement, you may be tempted to take a loan to cover emergencies or big expenses like college. But before you make that decision, there are some things you should know about 401k loan rules.
What Taxes Are There If You Leave Your Job Before Repaying Your 401 Loan
Many plans require you to repay your 401 loan in full if you leave your job. Other plans allow you to continue making payments.
If your plan requires you to pay in full when leaving your job, you have until the due date of your tax return to pay off your loan. For example, if you leave your job in February 2022, you have until April 2023 to repay the loan since the distribution would count for 2022 taxes filed by April 15, 2023. If you need even more time to repay the loan, you can request an extension of time to file your tax return and get another six months.
If you cant pay your loan in full, you owe taxes and penalties the same as for missing payments as described above.
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The Bottom Line: Find The Mortgage Option Thats Right For You
Your 401 account may seem tempting as an untapped source of cash, especially if youre struggling to come up with the money for a down payment on your new home. While this is a viable option, and there are ways to mitigate the penalties, it should only be used as a last resort. Consider applying for a low down-payment loan like an FHA or VA loan, or, if you have one, making a withdrawal from your IRA.
Whatever you decide, make sure you consult with a mortgage specialist before committing to an option. Rocket Mortgage® has experts waiting to help you navigate the tricky waters of home loans. If youre ready to take that next step toward a mortgage, then get preapproved today.
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Risks Of Taking Out A 401 Loan
Before deciding to borrow money from your 401, keep in mind that doing so has its drawbacks.
You may not get one. Having the option to get a 401 loan depends on your employer and the plan they have set up. A 2020 study from retirement data firm BrightScope and the Investment Company Institute says that 78 percent of plans gave participants the option to borrow based on 2017 data. So you may need to seek funds elsewhere.
You have limits. You might not be able to access as much cash as you need. The maximum loan amount is $50,000 or 50 percent of your vested account balance, whichever is less.
Old 401s dont count. If youre planning on tapping into a 401 from a company you no longer work for, youre out of luck. Unless youve rolled that money into your current 401 plan, you wont be able to use it.
You could pay taxes and penalties on it. If you dont repay your loan on time, the loan could turn into a distribution, which means you may end up paying taxes and bonus penalties on it.
Youll have to pay it back more quickly if you leave your job. If you change jobs, quit or get fired by your current employer, youll have to repay your outstanding 401 balance sooner than five years. Under the new tax law, 401 borrowers have until the due date of their federal income tax return to repay in such circumstances.
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When It Makes Sense To Borrow From Your 401
You should do other things first, but sometimes a 401 loan is a valid way to pay down high-interest credit card debt
Tapping your retirement plan to pay off high-interest debt sounds tempting, especially with interest rates on the rise. Then theres the added satisfaction of paying the interest on a 401 loan back to yourself, not the bank.
But theres a whole host of reasons why you shouldnt touch that money. Perhaps the biggest right now is that youre taking money out of the stock market after a major sell-off.
Chances are your account is down right now, so youre locking in a loss, says Lauren Lindsay, a certified financial planner based in Houston.
Thats why financial professionals recommend you explore other options before raiding your 401.
First Id be hammering on the expenses and seeing if theres anything that can be done to get some cash to throw toward the credit card, says Jim Holtzman, a wealth advisor based in Pittsburgh.
Among the strategies Holzman recommends: Call your credit card company and ask for a lower rate. Negotiate with the utilities to get a break for a period of time. Seek a credit counseling agency to negotiate with creditors. Shop at less expensive supermarkets, if you can.
Those arent fun processes to go through but youre really trying to lower that burden, he says.
There are times, however, when a 401 loan makes sense.
Here are some of the benefits of 401 loans:
Pros And Cons Of Borrowing From Your 401
Experts note investing steadily over the long term is the best way to ensure you have funds for retirement. So it’s a good idea to carefully consider the pros and cons of borrowing from your 401.
Pros
- A 401 loan doesn’t trigger a “hard” credit inquiry from the credit reporting firms and doesn’t appear on your credit report.
- Interest rates are set by the plan administrator and can be less than other kinds of loans.
- Interest on the loan goes back into the 401. You pay your own account for the loan.
- If you miss a payment on a 401 loan it won’t impact your credit score
- If you use the loan to pay off high-interest credit cards and pay the 401 loan back on time, you could reduce the amount you pay in interest overall.
Cons
- If you lose your job, you may have to repay the loan in full.
- Similarly, if you lose your job and don’t repay the loan by that year’s tax deadline, the IRS may consider your loan a withdrawal. If you’re younger than 59 ½, you’ll likely owe a 10% early withdrawal tax penalty.
- You can end up with a smaller retirement nest egg. That’s because investment gains will build off a smaller base while your loan is outstanding.
- If you stop contributing to the plan during the loan, you may miss out on matching funds offered by some employers.
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Borrowing From A 401k Loan Fees & Cost
Ballpark Estimate: Up to $350 in plan fees for a 5-year loan plus the cost of interest
If you are in need of money for some sudden or unexpected expenses, you may be tempted to borrow from your retirement account. This can be an easy-to-access source of funds to get you through an emergency situation. Yet some experts warn that this loan doesnt come without significant costs and responsibilities. Therefore, you should be prepared to get all of the facts before deciding if this is your best option.
Where Should You Transfer Your 401
You have several options on what to do with your 401 savings after retirement or when you change jobs. For example, you can:
The right choice depends on your needs, and thats a choice everybody needs to make after evaluating all of the options.
Want help finding the right place for your retirement savings? Thats exactly what I do. As a fee-only fidicuary advisor, I can provide advice whether you prefer to pay a flat fee or youd like me to handle investment management for you, and I dont earn any commissions. To help with that decision, learn more about me or take a look at the Pricing page to see if it makes sense to talk. Theres no obligation to chat.
Important:The different rules that apply to 401 and IRA accounts are confusing. Discuss any transfers with a professional advisor before you make any decisions. This article is not tax advice, and you need to verify details with a CPA and your employers plan administrator. Likewise, only an attorney authorized to work in your state can provide guidance on legal matters. Approach Financial, Inc. does not provide tax or legal services. This information might not be applicable to your situation, it may be out of date, and it may contain errors and omissions.
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