When A 401 Loan Makes Sense
When you mustfind the cash for a serious short-term liquidity need, a loan from your 401 plan probably is one of the first places you should look. Let’s define short-term as being roughly a year or less. Let’s define “serious liquidity need” as a serious one-time demand for funds or a lump-sum cash payment.
Kathryn B. Hauer, MBA, CFP®, a financial planner with Wilson David Investment Advisors and author of Financial Advice for Blue Collar America put it this way: “Lets face it, in the real world, sometimes people need money. Borrowing from your 401 can be financially smarter than taking out a cripplingly high-interest title loan, pawn, or payday loanor even a more reasonable personal loan. It will cost you less in the long run.”
Why is your 401 an attractive source for short-term loans? Because it can be the quickest, simplest, lowest-cost way to get the cash you need. Receiving a loan from your 401 is not a taxable event unless the loan limits and repayment rules are violated, and it has no impact on your .
Assuming you pay back a short-term loan on schedule, it usually will have little effect on your retirement savings progress. In fact, in some cases, it can even have a positive impact. Let’s dig a little deeper to explain why.
When A Problem Occurs
The vast majority of 401 plans operate fairly, efficiently and in a manner that satisfies everyone involved. But problems can arise. The Department of Labor lists signs that might alert you to potential problems with your plan including:
- consistently late or irregular account statements
- late or irregular investment of your contributions
- inaccurate account balance
Better Options For Emergency Cash Than An Early 401 Withdrawal
We know it can be a struggle when suddenly you need emergency cash for medical expenses, student loans, or crushing consumer debt. The extreme impact of coronavirus on public health and the economy has only compounded some of the more routine challenges of consumer cash flow.
We get it. 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, an advice and planning manager for Principal® Advised Services who helps clients on household money matters.
In short, he says, Youre harming your ability to reach retirement. More on that in a minute. First, lets cover your alternatives.
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Q: What Are Some Of The Reasons That Youd Want To Repay A 401k Loan As Quickly As Possible
Mr. Nordin: The single biggest reason is to get those funds back in your 401k growing free of taxes. The power of this over time is a huge ally toward having a sufficient retirement fund down the road.
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How Does Borrowing From My 401 Work
The IRS and your employer determine the conditions for a loan. The IRS sets the maximum you can borrow: $50,000, or 50% of your balance, whichever is less. Your spouse may need to sign that they agree to the loan.
In most plans, you can access the funds in a few days. Repayment is generally on a 5-year schedule, although often you can pay the loan off faster without incurring prepayment penalties. As long as you pay off the balance in time, you wonât pay taxes or penalties for accessing retirement funds early.
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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 .
A Deeper Dive On The 401 Loan Option
A loan is more strategic than a withdrawal, which torpedoes your savings altogether. With a full cash-out, instantly you lose a big chunk, paying a 10% penalty to the IRS if you leave the plan under age 55 plus another 20% for federal taxes. For instance, with a $50,000 withdrawal, you may keep just $32,500 and pay $17,500 in state and federal taxes. And the leftover sum you receive, if you happen to be in a higher tax bracket, may nudge you into paying even more taxes for that additional annual income.
Another adjustment in 2020 for workers affected by COVID-19: If your plan allows or through your IRA, you can withdraw up to $100,000 without the 10% penalty even if youre younger than 59½. The standard 20% federal tax withholding does not apply, but 10% withholding will unless you decide otherwise. You also can spread your income tax payments on the withdrawal over three years.
We understand emergencies can leave people with limited choices. Just remember that even the less extreme option of a 401 loan may paint your future self into a corner. 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.
At the very least, dont start stacking loans . Some employer retirement plans allow as many as three.
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How To Build Wealth With Compound Interest
First, we need to explain what compound interest is. With compound interest, unlike simple interest, you invest your money, earn money, and then invest that new money you made along with the sum you started out with, and that adds up year after year. Especially with considerable sums in your 401.
This is called compounding. Wealth is something that you create and compounding is a great way to do so. You can make money from both guaranteed and non-guaranteed investments while using compound interest. You can even take care of your retirement money this way.
Every year you can invest your money to make more money next year and save up for your future. These are the secrets of building wealth with compound interest. There are a lot of investment options out there that you can take and compound interest is closely related to retirement topics.
For example, if you invest $1,000 now in a guaranteed investment, years down the line your annual compound could go up to a couple of thousand dollars.
Before you start, you need to have a good foundation. Getting rid of consumer debt is your first step. If you dont pay off your credit card balance, you will be charged interest on your entire owning balance, including the interest added to your account the previous month. This will just make your credit card debt bigger.
After all, avoiding debt is one of the habits of millionaires.
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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When It Makes Sense
If you are deciding whether it makes sense for you to take out a loan from your 401, many financial experts say that it depends on what the money will be used for. For instance, you would not want to use your retirement fund to pay for a vacation or to buy a new car. But if you have unexpected medical bills or need it to help pay for an essential repair on your home, if you have nowhere else to turn for help, this may be a feasible last resort, especially if you will be able to repay the loan within the specified time period.
In addition, some people find it feasible to take out a retirement loan to buy a home. You can often stretch out the repayment of a loan for a home for as long as 15 years.
Early Withdrawals Less Attractive Than Loan
One alternative to a 401 loan is a hardship distribution as part of an early withdrawal, but that comes with all kinds of taxes and penalties. If you withdraw the funds before retirement age youll typically be hit with income taxes on any gains and may be assessed a 10 percent bonus penalty, depending on the nature of the hardship.
You can also claim a hardship distribution with an early withdrawal.
The IRS defines a hardship distribution as an immediate and heavy financial need of the employee, adding that the amount must be necessary to satisfy the financial need. This type of early withdrawal doesnt require you to pay it back, nor does it come with any penalties.
A hardship distribution through an early withdrawal covers a few different circumstances, including:
- Certain medical expenses
- Some costs for buying a principal home
- Tuition, fees and education expenses
- Costs to prevent getting evicted or foreclosed
- Funeral or burial expenses
- Emergency home repairs for uninsured casualty losses
Hardships can be relative, and yours may not qualify you for an early withdrawal.
This type of withdrawal doesnt require you to pay it back. But its a good idea to avoid an early withdrawal, if at all possible, because of the serious negative effects on your retirement funds. Here are a few ways to sidestep those hefty levies and keep your retirement on track.
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What Could Be The Cost Of Missed Retirement Savings
A report from the National Institute on Retirement Security found that 95% of millennials arent saving enough for retirement. And a 2017 study from Wells Fargo shows that other generations arent faring much better. So if youve been trying to beat the odds and put aside adequate savings for retirement, taking out a 401 loan can be a triple whammy.
First, some plans dont allow participants to make plan contributions while they have an outstanding loan. If it takes five years for you to repay your loan, that could mean five years without adding to your 401 account. During that time, you may be failing to grow your nest egg and youll miss out on the tax benefits of contributing to a 401.
Next, if your employer offers matching contributions, youll miss out those during any years you arent contributing to the plan. Loan repayments arent considered contributions, so if the employer contribution is dependent upon your participation in the plan, you may be out of luck if you cant make contributions while you repay the loan.
And finally, your account will miss out on investment returns on the money youve borrowed. Although you do earn interest on the loan, in a low-interest-rate environment you could potentially earn a much better rate of return if the money was invested in your 401.
What are the tax benefits of 401s?
Should I Take Out A Loan From My 401k
2021-03-11 401 k Loans Of the two borrowing from your 401 k is the more desirable option. Should i take out a loan from my 401k Homeowners with renovation projects more than 50000 must consider finding additional sources of funding aside from a 401k loan.
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Advantages Of Borrowing From A 401
Borrowing from your 401 isnt ideal, but it does have some advantages especially when compared to an early withdrawal.
A loan allows you to avoid paying the taxes and penalties that come with taking an early withdrawal. Additionally, the interest you pay on the loan will go back into your retirement account, although on a post-tax basis.
401 loans also wont require a credit check or be listed as debt on your credit report. If youre forced to default on the loan, you wont have to worry about it damaging your credit score because the default wont be reported to credit bureaus.
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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.
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What Are The Cons
Besides the fees, your employer will likely stop their side of the match, if they were making one. Even when youre paying yourself back, your employer wont consider those funds a new contribution and therefore wont match it. It also might make it more difficult to qualify for a mortgage, as it can affect your debt-to-income ratio you should still be sure to shop around to find a lender that can offer you the best program that fits your financial needs. And of course, youll lose out on the compound interest your money would have been earning if youd left it in the account.
Of course, if you decide to withdraw rather than borrow from your 401, the main con is the giant tax hit youll suffer.
How Does A 401 Loan Work
Madelyn Goodnight / The Balance
Borrowing from your 401 isnt the best ideaespecially if you dont have any other savings put toward your retirement years. However, when it comes to a financial emergency, your 401 can offer loan terms that you wont be able to find at any bank. Before you decide to borrow, make sure you fully understand the process and potential ramifications. Below are seven things you need to know about 401 loans before you take one out.
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Is It A Good Idea To Borrow From Your 401
Using a 401 loan for elective expenses like entertainment or gifts isn’t a healthy habit. In most cases, it would be better to leave your retirement savings fully invested and find another source of cash.
On the flip side of what’s been discussed so far, borrowing from your 401 might be beneficial long-termand could even help your overall finances. For example, using a 401 loan to pay off high-interest debt, like credit cards, could reduce the amount you pay in interest to lenders. What’s more, 401 loans don’t require a credit check, and they don’t show up as debt on your credit report.
Another potentially positive way to use a 401 loan is to fund major home improvement projects that raise the value of your property enough to offset the fact that you are paying the loan back with after-tax money, as well as any foregone retirement savings.
If you decide a 401 loan is right for you, here are some helpful tips:
- Pay it off on time and in full
- Avoid borrowing more than you need or too many times
- Continue saving for retirement
It might be tempting to reduce or pause your contributions while you’re paying off your loan, but keeping up with your regular contributions is essential to keeping your retirement strategy on track.
Long-term impact of taking $15,000 from a $38,000 account balance
