How Do 401 Loans Work
When you think of borrowing money, you likely imagine filling out a loan application, waiting for a credit approval, and then receiving your funds.
Its different when you borrow from a 401.
A 401 loan doesnt come from a bank, but rather from your own retirement funds.
For this reason, the process is much quicker than getting a traditional loan.
Calculate How Much Of Your Retirement Is At Risk
Having a 401k is crucial for your financial future, and the government tries to reinforce that for your best interest. To encourage people to save, anyone who withdraws their 401k early pays a 10 percent penalty fee. When, or if, you go to withdraw your earnings early, you may have to pay taxes on the amount you withdraw. Your tax rates will depend on federal income and state taxes where you reside.
Say youre in your early twenties and you have 40 years until youd like to retire. You decide to take out $10,000 to put towards your student loans. Your federal tax rate is 10 percent and your state tax is four percent. With the 10 percent penalty fee, federal tax, and state tax, you would receive $7,600 of your $10,000 withdrawal. The extra $2,400 expense would be paid in taxes and penalties.
The bottom line: No matter how much you withdraw early from your 401k, you will face significant fees. These fees include federal taxes, state taxes, and penalty fees.
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The Dangers Of Taking Out A Loan On Your 401k
I want to stress to you that taking out a personal loan or getting in the habit of borrowing money from your 401k is not a great idea. If you withdraw funds or take a loan from your 401k to pay your debts, there is no guarantee you fixed the problem that got you in debt in the first place. Remember, you are punishing your future self and your ability to retire comfortably by using it today.
The Cons Of Borrowing From Your 401k
Up until now, using a 401k loan to pay off debt you owe to the IRS must seem like a pretty great deal.
You dont really pay interest, you can avoid a credit check, and youll be able to access the money incredibly quickly.
As with any type of loan, however, there are a few reasons why this might not be the right move for you.
First of all, whenever you borrow from your retirement savings, youre putting your financial future at risk. This is especially true given that when you pay back what youve borrowed, you must repay it with after-tax funds.
If youre in a 20% tax bracket, for example, every dollar you put towards repaying a 401k loan is actually only 80 cents. Its easy to see how over time, this could chip away at your retirement savings in a pretty significant way.
Additionally, depending on employer regulations, you may not be allowed to continue to make contributions to your 401k until youve completely repaid your loan. This is, perhaps, the biggest reason to look into other avenues of paying back your taxes.
Remember too that youre also missing out on the opportunity for the money you took from your 401k account to earn any kind of investment returns.
Plus, you need to consider the unfortunate reality of an even greater potential financial hardship. What if you become ill and are faced with high medical bills? What if your home is hit by a natural disaster?
Youll be hit with another 10% early withdrawal fee.
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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.
Why You May Want To Consider A Personal Loan Instead
To be sure, borrowing from your 401 comes with some significant downsides, even in the situations above.
First and foremost is the fact that your 401 is meant to be a retirement savings account, and borrowing from it in the short term at least temporarily sacrifices the growth of that money. Then theres the fact that if you leave your company, youll typically have to pay back the loan within 90 days or else the remaining balance is considered a withdrawal subject to taxes and penalties.
On top of all that, your employer may not allow you to make 401 contributions as long as you have an outstanding loan balance, which further sacrifices your ability to save for retirement.
With those downsides, it often makes sense to consider taking out a personal loan before resorting to a 401 loan. You can borrow the money you need without sacrificing your retirement savings and you arent running the risk of having to immediately pay back the entire balance if you lose your job.
The biggest disadvantages of a personal loan compared with a 401 are the stricter credit requirements and the potential for a higher interest rate. There may also be an origination fee that increases the cost of the loan.
But at the end of the day, a personal loan is often the safer option because it avoids the biggest risks that come with a 401 loan.
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When To Use 401k To Pay Off Debt
If you are struggling to pay debts, you may consider using your 401 to keep the debts under control. Find out when you can use 401 to pay off debt.
After years of hard work, you might have accumulated a nice nest egg, and you may be tempted to use some of it to deal with the piling debts instead of leaving the money untouched for your retirement. While it is a bad idea to tap into your retirement savings, there are certain situations when it makes sense to use your 401 to pay off debt.
You can use a 401 to pay off high-interest debts like credit card loans since it can reduce the interest you pay. If you opt for a 401 loan, you can drastically reduce the interest rate from 15% – 20% to below 5%, and you will be paying the principal and interest to your 401. Also, if you are on the verge of default, a 401 can help you avoid further fees, penalties, and prevent further damage to your credit report and credit score.
What Is A 401k Loan
We know that the thought of borrowing from your 401k can make you feel anxious.
After all, that money is meant to be used to help you in your retirement.
While borrowing from your 401k to finance your dream wedding or buy a home that you truly cant afford is never a smart move, borrowing from it to pay your back taxes is one of the rare times when tapping into your 401k plan can be acceptable.
Its important to understand that 401k loans arent loans in the traditional sense.
Instead, the only real person that youre borrowing money from is yourself, and you wont need to get approval from a lender to get the money.
While every employer has slightly different rules regarding early access to 401ks, in general, youre allowed to borrow the lesser value of either 50% of your 401k plan or $50,000.
Another common question is, Do I have to pay taxes on a 401k loan? The answer is no, which is another reason why using a 401k to pay off debt from back taxes is a good move for some.
In addition to not having to pay taxes, the interest charged on your 401k loan actually goes back into your 401k account. Basically, youll end up moving that money from one account to another.
Especially if you know you cant afford to pay the high-interest rates on a credit card or another type of loan, borrowing from your 401k may be a smart move.
As of this writing, about 1/3 of Americans say that they have borrowed from their retirement savings in some 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:
- 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.
Youll Miss Out On Market Gains
Borrowing from your 401 will decrease the amount of money in your retirement account.
Even if you borrow funds for a good purpose, less money in your account means youll miss out on market gains and compounded earningswhich you would have received if you left the funds in the account.
For example, if you have $30,000 in a 401 and you borrow $10,000, youll only earn gains on the $20,000 until you repay the loan.
Slower gains can also occur if you temporarily lower your 401 contributions while paying back your loan.
Putting less money in your retirement account also reduces how much your employer contributes, if the company you work for offers a match program.
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Should I Pay Off My Credit Card Debt With A 401 Loan
Tapping into a 401k can be a good idea if you have high credit card expenses or other loans with high interest, Gozeh tells Finder. Although a 401 loan is easier to get than a debt consolidation loan or a balance transfer credit card because it doesnt require a credit check, you still run the risk of penalties, taxes and running up big balances again unless you change your spending habits.
More Pros Of A 401k Loan
In addition to not being charged taxes and high-interest rates when taking a loan from a 401k to pay off debt, there are a few other reasons why it may be a smart idea.
The process of getting the money in your pocket is much faster and easier than the often lengthy process of applying for a traditional loan. In most cases, you wont even need to undergo a credit check in order to access funds from your 401k.
Plus, when you take out the loan, you can rest easy knowing that your credit score wont be negatively affected.
In most cases, youll have five years to pay back your 401k loan, which is a much longer repayment period than other types of bank or third-party lender loans. Usually, when you borrow from your 401k, there is no penalty for early repayment.
Youll be able to enjoy a bit of repayment flexibility here, as well. You can even set up automatic payroll deductions so that you can pay back the money you borrowed without a second thought.
Plus, the interest rate on a 401k loan is only about 4-5%. Credit cards generally carry an interest rate of 15% or highermeaning that its easier than ever to get trapped into an endless cycle of debt.
Finally, youll be able to avoid those hefty loan initiation fees that you often get hit with when you borrow from a traditional lender or bank.
However, paying taxes on 401k plans do have some drawbacks you need to consider.
Lets take a closer look at the reasons you may want to look into other options below.
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Looking For More Tax Advice
We hope that this post has helped you to be able to make a sound decision about whether or not using a 401k loan to pay off debts to the IRS is the right move for you.
If its not your best option, consider speaking with a tax or financial professional to help you better understand the other options weve discussed here.
No one enjoys dealing with the burden of back taxes, taking money from their retirement funds, and dealing with high-interest rates on loans. However, the inability to repay your taxes on time is just one of the many issues with your tax return that you could face.
Are you in need of actionable tax advice that will save you time, stress, and most of all, money?
We can help.
Reach out to us today for a free tax evaluation, and dont face the IRS on your own.
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How Much Can I Borrow From My 401k
Current IRS rules allow you to borrow up to 50% of your vested account balance or $50,000, whatever amount is less. However, if your account balance is $10,000 or less, you can borrow up to the total balance or $10,000, whichever is less.
Whatever amount you borrow generally must be repaid in five years.
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Increase Your Investment Return
There are certain situations where you can use a 401 loan to increase your overall investment return. Heres a hypothetical example showing how it can work.
Lets say that the following things are true:
- Your 401 money is invested partially in a stock mutual fund and partially in a bond mutual fund.
- The bond mutual fund currently has an SEC Yield of 1.97%, meaning you can expect about a 1.97% return from that fund going forward .
- You can borrow money from your 401 at 4.5%.
Given that scenario, here are the steps you could take to increase your expected investment return while only adding a small amount of risk:
In other words, youre getting essentially the same return on your bond fund in the taxable account, minus the tax cost. But you get a higher return in your 401 because the interest rate is higher than the expected return on the bond fund.
Here are a few things to keep in mind as you consider this approach:
Alternatives To Borrowing From Your 401
Some 401 plans allow hardship withdrawals for circumstances like preventing eviction from your apartment or making needed repairs to your home. If you take a hardship withdrawal, you will pay federal and possibly state income taxes on the amount you withdraw, as well as a 10% federal tax penalty if you are not yet age 59 1/2.
You might also consider borrowing money from a bank or a relative. And if you owe a lot of money, you could consult with a to find ways to help you get out of debt. As a last resort, you might decide to hire a bankruptcy attorney to wipe out your debt while preserving your 401 and other retirement money.
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