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A Quick Review Of The 401 Rules
A 401 account is earmarked to save for retirementthat’s why account holders get the tax breaks. In return for giving a deduction on the money contributed to the plan and for letting that money grow tax-free, the government severely limits account holders’ access to the funds.
Not until you turn 59½ are you supposed to withdraw fundsor age 55, if you’ve left or lost your job. If neither is the case, and you do take money out, you incur a 10% early withdrawal penalty on the sum withdrawn. To add insult to injury, account holders also owe regular income tax on the amount .
Still, it is your money, and you’ve got a right to it. If you want to use the funds to buy a house, you have two options: borrow from your 401 or withdraw the money from your 401.
The True Cost Of A 401 Loan
Any money you borrow from your retirement fund misses both market gains and the magic of compound interest.
Just imagine taking out a five-year 401 loan during this current bull market at 30 or 35 years old it could severely impact your future nest egg, says Malik Lee, a certified financial planner at Henssler Financial in Kennesaw, Georgia.
According to Vanguards 401 loan calculator, borrowing $10,000 from a 401 plan over five years means forgoing a $1,989 investment return and ending the five years with a balance that’s $666 lower.
But the cost to your retirement account doesnt end there. If you have 30 years until retirement, that missing $666 could have grown to $5,407, according to NerdWallets compound interest calculator .
Moreover, many people reduce their 401 contributions while making payments on a loan from the plan. In fact, some plans prohibit contributions when a loan is outstanding. This further damages retirement plans.
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If You Take A 401 Loan You’ll Pay Interest To Yourself
When you borrow against your 401, you have to pay interest on your loan. The good news is, you’ll be paying that interest to yourself. Your plan administrator will determine the interest rate, which is usually based on whatever the current prime rate is.
The bad news is, 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.
Is Borrowing From Your 401 A Good Idea Financial Advisor In Annapolis Explains
COVID-19 made 2020 a difficult year, to say the least. Many people found themselves out of work, logging less hours or contemplating how to keep their businesses afloat during a nationwide shutdown. While government stimulus programs attempted to help, many people wondered how theyd survive financially and some turned to their employer-sponsored retirement plans to make ends meet.
Regardless of why, its important to understand what making an early withdrawal from your 401 or other retirement plan really means. There could be penalties, taxes and other costs to consider.
As a financial advisor in Annapolis, MD, theres a lot of confusion about how retirement plans work, so the team at Scarborough Capital Management has created this refresher. If you have a question that is not addressed here or are considering borrowing from your retirement plan, lets talk. A no-obligation conversation can go a long way.
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K Plan Early Withdrawal Penalty Exceptions
According to the IRS, several exceptions allow you to take money out of your 401k before the age of 59 1/2. The following are qualifying exemptions:
- Death
- If you die early, the government will let your beneficiaries access your retirement account without penalty
**Be sure to check with a tax professional before taking money out of your 401k plan to ensure tax laws have not changed.
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.
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If You Lose Your Job You May Have To Repay The Money By Tax Day Next Year
Departing from your job used to trigger a requirement that you repay your loan within 60 days. However, the rules changed in 2018. Now, you’ll have until tax day for the year you took the withdrawal to pay what you owe.
So if you borrowed in 2020 and lost your job, you’ll have to repay the full balance of your loan by April 15, 2021 . The CARES Act did not change this rule for loans taken in 2020. Similarly, if you borrow in 2021, you will need to repay the full balance by April 15, 2022 .
This longer deadline does slightly reduce the risks of borrowing. But if you take out a loan now, spend the money, and then are faced with an unexpected job loss, it could be hard to repay your loan in full.
Should I Borrow From My 401
Borrowing from a 401 to pay off debt may seem like an attractive option, but it comes with a major tradeoff a . In addition to having less savings in your retirement account to hold you over during your golden years, you could also be slammed with penalty fees for withdrawing from your 401 early.
According to the IRS, if you withdraw from your 401 before the age of 59 ½, you will be required to pay a 10% early withdrawal penalty in addition to income tax on the distribution. While it may be easy to borrow from your retirement fund, it is wise to consider the post-retirement implications borrowing from this source could cause.
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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.
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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Other Alternatives To A 401 Loan
Borrowing from yourself may be a simple option, but its probably not your only option. Here are a few other places to find money.
Use your savings. Your emergency cash or other savings can be crucial right now and why you have emergency savings in the first place. Always try to find the best rate on an online savings account so that youre earning the highest amount on your funds.
Take out a personal loan. Personal loan terms could be easier for you to repay without having to jeopardize your retirement funds. Depending on your lender, you can get your money within a day or so. 401 loans might not be as immediate.
Try a HELOC. A home equity line of credit, or HELOC, is a good option if you own your home and have enough equity to borrow against. You can take out what you need, when you need it, up to the limit youre approved for. As revolving credit, its similar to a credit card and the cash is there when you need it.
Get a home equity loan. This type of loan can usually get you a lower interest rate, but keep in mind that your home is used as collateral. This is an installment loan, not revolving credit like a HELOC, so its good if you know exactly how much you need and what it will be used for. While easier to get, make sure you can pay this loan back or risk going into default on your home.
Retirement Savings Can Benefit
As you make loan repayments to your 401 account, they usually are allocated back into your portfolio’s investments. You will repay the account a bit more than you borrowed from it, and the difference is called “interest.” The loan produces no impact on your retirement if any lost investment earnings match the “interest” paid ini.e., earnings opportunities are offset dollar-for-dollar by interest payments.
If the interest paid exceeds any lost investment earnings, taking a 401 loan can actually increase your retirement savings progress. Keep in mind, however, that this will proportionally reduce your personal savings.
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How Long Do You Have To Repay A 401 Loan
Generally, you have up to five years to repay a 401 loan, although the term may be longer if youre using the money to buy your principal residence. IRS guidance says that loans should be repaid in substantially equal payments that include principal and interest and that are paid at least quarterly. Your plan may also allow you to repay your loan through payroll deductions.
The CARES Act allows plan sponsors to provide qualified borrowers with up to an additional year to pay off their 401 loans.
The interest rate youll pay on the loan is typically determined by the plan administrator based on the current prime rate, but it and the repayment schedule should be similar to what you might expect to receive from a bank loan. Also, the interest isnt paid to a lender since youre borrowing your own money, the interest you pay is added to your own 401 account.
Those Who Can Pay Themselves Back
Its not free money. You have to pay it back or risk getting hit with a hefty tax bill, says Jeff Levine, of Nerds Eye View, an online news source that caters to financial planners.
Someone who may not be able to pay it back should think a little harder about whether they should tap into their retirement assets or not, Pfau says.
Another thing to keep in mind is how close you are to retirement. For many people, this could force them into an early retirement. Borrowing from their 401 may just be a way of actually starting to take distributions for retirement earlier, Pfau says. You just have to recognize the trade-offs, like not having as much money for retirement down the road.
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How Much Can You Borrow
Plans can set their own limits for how much participants can borrow, but the IRS establishes a maximum allowable amount. If your plan permits loans, you can typically borrow $10,000 or 50% of your vested account balance, whichever is greater, but not more than $50,000.
But the CARES Act provides some exceptions to that limit. The law allows those who qualify to borrow up to $100,000 loans from your plan) or 100% of your vested account balance, whichever is less. That provision expires on Sept. 22, 2020.
To qualify, you likely need to fall within at least one of several scenarios, including
- You, your spouse or a dependent is diagnosed with COVID-19
- You experience financial hardship as a result of being quarantined, furloughed or laid off, or your hours are reduced because of COVID-19
- You cant work and are experiencing financial hardship because the COVID-19 crisis has cut off your access to childcare
- You have financial troubles because a business you operate or work for closes or reduces its hours as a result of COVID-19
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The Best Method To Pay Off Debt
The absolute best way to take care of that suffocating debt is to leave your retirement alone.
Do not rob your future self to pay the debts of your present self.
While you are young and healthy, you should be using this time to pay off your debts as soon as humanly possible. Pick up a side hustle, and sell everything you no longer use. Host yard sales, get on a budget and bear down to destroy this debt.
Do not pay the extra 10% tax penalty by pulling your money out early in any circumstance. There is always an alternative to taking from or borrowing from your 401k. However, you are an adult and you are going to do what you want. If you are determined to take from your retirement, at least take a loan from it instead. Force yourself to repay your future self with interest.
