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 that you’ll 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.
Costs Associated With 401 Loans And Withdrawals
We mentioned some costs associated with taking out a loan or making a withdrawal from your 401 account. These include taxes and penalties.
If you take out a loan from your 401, you will have to pay interest on the loan. The interest rate is usually lower than the rate you would pay on a personal loan, but it is still worth considering. Additionally, if you withdraw from your 401, you will have to pay taxes and penalties on the amount.
The tax rate will depend on your income level and the type of withdrawal you made. For example, if you take out a hardship withdrawal, you may have to pay an additional penalty if the amount exceeds $10,000, and you wont be able to pay it back, only contribute to your 401 later. Also, if you are under the age of 59 ½, you will likely have to pay a 10% penalty on the amount you withdrew.
An Alternative: Irs Installment Agreements
Barbara Weltman, an editor of J.K. Lassers Your Income Tax 2016, is not a fan of using a 401 to pay your taxes. Your 401 should be your retirement money, she said.
Weltman thinks a better alternative if you’re short on cash is to get an installment agreement with the IRS to pay your taxes .
Anyone who owes $50,000 in taxes, penalties and interest and has filed a return can apply some people qualify if they owe under $100,000. And youre guaranteed approval if you owe less than $10,000 have filed your returns on time during the past five years and agree to pay the full amount you owe within three years.
If you owe less than $10,000, you can generally fill out the agreement online and set it up as an automatic payment plan from your bank account, Weltman said. IRS interest rates on installment agreements are so low, she added. Youll pay the federal short-term rate plus 3% today, about 4%.
Theres no setup fee if you qualify for a short-term IRS installment agreement of 120 days or less otherwise, youll owe the IRS $43 to $120, depending on your income and whether you have the money debited from your bank account.
Whatever you decide to do to come up with the cash, be sure you file your tax return on time and pay something when you do. Otherwise, the IRS will slap you with a late-filing penalty and a late-payment penalty .
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How Does A 401 Loan Work Advantages And Disadvantages
Pinyo BhulipongsanonAdvertiser Disclosure:
Are you thinking about borrowing money from your 401 plan? Whether it is for the down payment for your home purchase, for debt payment, to fund your new business venture, or to cover your cash shortfall borrowing money from your 401 is a decision that you need to consider carefully.
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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.
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Interest And Fees Will Accrue
Another thing to consider before borrowing against your retirement fund is in respect to the various fees and interest rates you will be charged. Most plans charge a one-time loan origination fee that can be upwards of $75, regardless of the size of the loan. This means that even if you were to borrow $1,000 and they charged a $75 fee, youre losing 7.5% right off the top.
In addition to fees, you also have to pay interest just as you would on any other loan. The one good thing about the interest is that you are actually paying yourself the interest. So, you are actually putting a little bit more money into your account instead of a bank receiving the interest. A common interest rate is the current prime rate plus 1%. While that may be less than what you’d pay for a personal loan from a bank, interest is still interest so you’d have to consider whether borrowing is truly worthwhile.
Why You Shouldn’t Take A 401 Loan
It’s awfully tempting. You see that money in your 401 plan account just sitting there. And you think of all the possible uses for it. Why not take a loan? You will pay it back — with interest!
Generally, that is a really bad idea. Here are the reasons why.
You will likely forfeit some company matching contributions
Many individuals who borrow from their 401 accounts end up stopping or lowering their contributions while they are paying back their loans. This often results in the loss of 401 matching contributions when their contribution rates fall below the maximum matched percentage.
There is no better investment you can make than receiving free money in the form of company matching contributions. It is the safest, easiest way to earn 25%, 50% or 100% — depending upon your company’s matching percentage.
Job changes can force defaults
Most individuals considering a job change don’t realize that their outstanding 401 loan balance becomes due when they leave their employer. In the case of an involuntary job loss, an outstanding 401 loan can add significant pain to an already difficult situation.
Regardless of whether a job change is voluntary or involuntary, few of us have the financial resources available to immediately pay back a 401 loan if we leave our employer. As a result, most of us are forced to default. Note, the new tax law gives a little leeway on the time to repay until your tax return due date the next year.
The opportunity costs can be substantial
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Can I Use My 401 To Buy A House
Using your 401 to make a downpayment on a house is generally allowed.
There are even some benefits:401 loans arent taxed, they dont affect your credit score,and they havelow interest rates.
However, borrowing from your401 can do severe and lasting damage to your retirementsavings. Thats why financial advisors recommend borrowers tap their 401 fundsonly as a last resort.
Before you decide to use your 401 to buy a house, consider the no- and low-down-payment mortgages available today.
Many people can buy a house withas little as 3% or even 0% down so theres a good chance you dont need totap your retirement savings to make a down payment.
If You Can’t Pay It Back You Get Hit With A Big Tax Bill
When you take a 401 loan, you typically must make payments at least once per quarter and must have the entire loan repaid within five years, although there are exceptions such as a longer repayment period if the money you borrow is used as a down payment for a primary home.
If you are not able to comply with the repayment rules, the entire unpaid amount of the loan becomes taxable. Plus, if you’re under 59 1/2, you will not only have to pay federal and state taxes on the money you withdrew but will also have to pay a 10% penalty for early withdrawal.
Depending upon your federal tax bracket and state taxes where you live, your total tax bill could be around 40% or more of the amount withdrawn for example, if you were in the 25% federal tax bracket, paid 8% California state tax, and paid a 10% penalty for withdrawing money early, you’d owe 43% in taxes. If you borrowed $10,000, the government would get $4,300 and you’d be left with just $5,700.
That’s a really high effective interest rate — so you’re taking a big gamble that you’ll be able to make all the repayments without a hitch.
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Drawbacks To 401 Loans
Now the downsides to 401 loans:
Theres a limit to how much you can borrow no more than 50% of your vested account balance or $50,000, whichever is less. One exception: if your 401 has less than $20,000, you may be able to borrow up to $10,000.
Another drawback: If you leave your employer before your 401 is paid off, youll need to either come up with the rest of the cash within 60 days or face a tax bill, because the IRS will view the outstanding loan as a taxable distribution. If youre under 55, thatll mean paying ordinary income tax on the money and probably a 10% penalty.
Also, it can take about a month to get your hands on the money once you apply for a 401 loan. So youll likely need to ask for one by early- or mid-March to ensure you’ll have the funds when your tax return is due. It can be a bit of an administrative nightmare, said Meadows. Loan checks are not easy to cut. So you dont want to wait until April 1 to get the ball rolling.
And, of course, with a 401 loan youll miss out on any tax-deferred earnings you wouldve had if you hadnt borrowed from the plan. You probably wont see the growth in your 401 as you would have seen without the loan, said Meadows. More money makes more money.
Borrowing Against Your 401 Is It Ever A Good Idea
Many full-time and part time employees have the benefit of a company-matched retirement plan, referred to as a 401 for the part of the tax code authorizing it. These tax-deferred packages are the principal retirement vehicle for just over half of people in the United States. Americans put away about 6% of their pay in 401 plans to receive employee matching and tax breaks.
One feature many people dont realize about 401 funds is that the account holder can borrow against the balance of the account. About 87% of funds offer this feature. The account holder can borrow up to 50% of the balance or $50,000, whichever is lower, but the whole amount must be repaid within 5 years. Theres no approval process and theres no interest. Its basically a loan you give yourself, and is a popular enough option that 17% of millennial workers, 13% of Gen Xers and 10% of baby boomers have made loans against their 401 accounts.
Despite these benefits, borrowing against a 401 is a risky proposition. There are harsh penalties for failure to repay and taking money away from retirement savings is always risky. Borrowing from a 401 account should not be a decision that is made lightly.
As with most financial moves, there are benefits and disadvantages to borrowing from a 401. It can be difficult to sort through them, particularly if your need for money is acute and immediate. Before you borrow from a 401, though, ask yourself these four questions:
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How Long Before I Must Repay
Typically, you must repay in one to five years, unless the loan is for the purchase of a primary residence. A repayment schedule will be part of the loan agreement. For details, check your plan.
Key takeaway: Before you begin the process of borrowing against your 401, find out whether your plan allows it, how much you can borrow, what the interest rate is and how long you have to repay.
Reasons To Take A 401 Loan
If you do a quick search, youll find people offering many different reasons to take a loan from your 401. These vary from:
- Short-term liquidity needs
- Your job is secure
- For a smart investment
I want to contend with you these are actually reasons NOT to take out a 401 loan! The last thing you want to do is turn your 401 into just another credit card that makes it easier for you to spend more money you dont have.
The reality is that a fully funded emergency fund is a much better alternative for short-term cash needs. Its easier, more flexible and costs less. Not to mention, having an emergency fund can help keep you from getting into further financial trouble when unexpected events occur.
If you dont have an emergency fund and have a lot of non-mortgage debt, contact me! I will help point you in the right direction on how to get rid of the debt for good.
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You’ll Be Stuck In Your Job Or Forced To Pay Back The Loan Early
When you leave your job and you have an outstanding 401 loan, you typically have to pay the loan back right away or your employer will alert the IRS and taxes and penalties will be triggered. The specific length of time you have to pay can vary from plan-to-plan, but 60 days is typical.
This means that unless you have the cash, you’re left with a choice between sticking it out at your job until you’ve repaid the entire balance — which could take years — or paying a hefty sum to the government. You could be forced to forego career opportunities to avoid the tax hit… assuming you actually have a choice about whether you leave your job and don’t get laid off first.
If you are let go, you’ll still be forced to repay the loan or pay taxes. This could mean coming up with a lot of cash right when you’ve lost the income that your job was providing.
Loans Are Tied To Your Company
If you leave your job, youre still required to pay the balance of any 401 loans.
If you don’t repay, and you sever ties with your existing company for whatever reason, the IRS will deem the loan a distribution, and you will be taxed in that tax year, says Allan Katz, certified financial planner at Comprehensive Wealth Management Group in Staten Island, New York. And if youre younger than 59½, youll incur a 10% early withdrawal penalty.
You could be left in a deeper financial hole than the one caused by your credit card debt.
About 86% of people who leave their job with an outstanding 401 loan default on it, according to the National Bureau of Economic Research, compared with 10% of all 401 loan borrowers.
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Should You Get A 401 Loan To Pay Your Taxes
As Tax Day approaches , you may be looking at a whopper of a tax bill and wondering where youll find the money to pay it.
And then you might think: Hmmm, I have some money sitting in my 401. Maybe I should take out a 401 loan to write a check to the IRS.
About 90% of 401 participants are able to borrow against their balance and roughly 11% do each year. By contrast, you cant borrow against an Individual Retirement Account. So should you take out a 401 loan for your taxes? Maybe.
If You’ve Got A Pressing Financial Concern And Money In Your 401 You May Be Tempted To Take The Cash Out By Taking A 401 Loan After All The Money Is Just Sitting There You’d Be Paying Interest To Yourself If You Took Out The Cash And You May Have Plenty Of Time To Put The Money Back Before Retirement
While it can theoretically seem like a smart financial move to use that money to pay off high-interest debt, put down a down payment on a house, or fulfill another immediate need, you should resist the urge and leave your 401 cash right where it is. The money already has a job — helping you afford food, housing, and medicine when you’re too old to work — and the only reason you should ever take it out is for a true life-and-death emergency.
Here are four big reasons why you should leave the money in your 401 alone so you don’t have major regrets later.
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What Is A 401 Loan
A 401 loan allows you to borrow money youve saved up in your retirement account with the intent to pay yourself back. Even though youre lending money to yourself, its still treated like a normal loan by charging interest that youre on the hook for.
When you take out a loan from your 401 plan, youll get terms like you would with any other type of loan: Theres a repayment plan based on how much you borrow and the interest rate you lock in. According to IRS rules, you have five years to pay back the loan, unless the funds are used to buy your main home, in which case you have more time to repay.
A 401 loan has some key disadvantages, however. While youll pay yourself back, one major drawback is youre still removing money from your retirement account that is growing tax-free. And the less money in your plan, the less money that grows over time. Even when you pay the money back, it has less time to fully grow.
In addition, if you have a traditional 401 plan, youll be repaying the pre-tax funds in the account with your after-tax earnings, so it takes even more in terms of working hours to repay the loan.
