When Faced With A Sudden Cash Crunch It Can Be Tempting To Tap Your 401 More Than A Few Individuals Have Raided Their Retirement Account For Everything From Medical Emergencies To A Week
But if you’re under 59-1/2, keep in mind that an early withdrawal from your 401 will cost you dearly. You’re robbing your future piggy bank to solve problems in the present.
You’ll miss the compounded earnings you’d otherwise receive, you’ll likely get stuck with early withdrawal penalties, and you’ll certainly have to pay income tax on the amount withdrawn to Uncle Sam.
If you absolutely must draw from your 401 before 59-1/2, and emergencies do crop up, there are a few ways it can be done.
Hardship withdrawals
You are allowed to make withdrawals, for example, for certain qualified hardships — though you’ll probably still face a 10% early withdrawal penalty if you’re under 59-1/2, plus owe ordinary income taxes. Comb the fine print in your 401 plan prospectus. It will spell out what qualifies as a hardship.
Although every plan varies, that may include withdrawals after the onset of sudden disability, money for the purchase of a first home, money for burial or funeral costs, money for repair of damages to your principal residence, money for payment of higher education expenses, money for payments necessary to prevent eviction or foreclosure, and money for certain medical expenses that aren’t reimbursed by your insurer.
Loans
Most major companies also offer a loan provision on their 401 plans that allow you to borrow against your account and repay yourself with interest.
You then repay the loan with interest, through deductions taken directly from your paychecks.
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.
Accessibility Of 401 Funds
The 401 plan has some great features, such as tax-deferred status, matching contributions and catch-up provisions for older savers. That said, one of their drawbacks is lack of accessibility. The structure of a 401 account is different from that of a traditional individual retirement account .
While an IRA is held in the name of the account holder, a 401 account is held in the name of an individuals employer on the individuals behalf. The specific 401 plan offered through the employer governs the circumstances under which individuals can withdraw money from the account, and many employers only allow early withdrawals in the event of severe financial hardship. This basic structural fact regarding 401 accounts is one of the main factors that present obstacles to using account funds as collateral for a loan.
One of the other primary reasons stems from the fact that these accounts are specifically protected from creditors by the Employee Retirement Income Security Act, or ERISA. Therefore, if a 401 were used as collateral for a loan, the creditor would have no means of collecting from the account in the event the borrower defaulted on the loan payments.
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Borrowing From An Ira
Unlike a 401, borrowing from an IRA account is prohibited by the IRS. There are situations in which an IRA withdrawal can be made without the early withdrawal penalty for those under age 59 1/2, such as paying for college or buying a first home. Its also possible to free up IRA funds for a 60-day period by rolling over an IRA balance from one account to another. If the money is not deposited within 60 days, its treated as a distribution by the IRS and you could face an early withdrawal penalty. As long as this penalty is avoided, an IRA rollover might be a good alternative for a retiree thinking about a 401 loan for a short-term cash flow emergency.
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Factor In Whenand Howyou Have To Pay It Back
Youre borrowing your own money, but you do have to pay it back on time. If you dont, the loan is considered a taxable distribution and youll pay ordinary income taxes on it. If youre under 59½, youll also be hit with a 10 percent penalty. Put that in real dollars: If youre 55, in the 25 percent tax bracket, and you default on a $20,000 loan, it could potentially cost you $5,000 in taxes and $2,000 in penalties. Thats a pretty hefty price to pay for the use of your own money!
Before borrowing, figure out if you can comfortably pay back the loan. The maximum term of a 401 loan is five years unless youre borrowing to buy a home, in which case it can be longer. Some employers allow you to repay faster, with no prepayment penalty. In any case, the repayment schedule is usually determined by your plan. Often, paymentswith interestare automatically deducted from your paychecks. At the very least, you must make payments quarterly. So ask yourself: If youre short on cash now, where will you find the cash to repay the loan?
Who Should Withdraw From Their 401 Early
Just because you qualify for a hardship-related withdrawal doesnt mean you should take one without weighing all your other options.
The experts we spoke with were all in agreement that withdrawing from your 401 shouldnt be your first move. However, they also indicated that if youre truly in need, then you should take advantage of the CARES Acts allowances.
It should be a last resort option. People shouldnt get carried away and start using their 401 assets just because they can, Pfau says.
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Is Borrowing From 401k A Good Idea
Key Takeaways. When done for the right reasons, taking a short-term 401 loan and paying it back on schedule isnt necessarily a bad idea. Reasons to borrow from your 401 include speed and convenience, repayment flexibility, cost advantage, and potential benefits to your retirement savings in a down market.
Do You Qualify For A Hardship Distribution
If your plan allows it, you might qualify for a hardship distribution. But doing so isnt easy. First, you must prove what the IRS considers immediate and heavy financial need. In general, the IRS defines this as:
- Medical expenses for you, your spouse, or dependents
- Costs directly related to the purchase of your principal residence
- Postsecondary tuition and related educational fees, including room and board for you, your spouse, or dependents
- Payments necessary to prevent you from being foreclosed on or evicted from your principal residence
- Funeral expenses
- Certain expenses relating to the repair of damage to your principal residence
The amount of the distribution is limited to your own contributions to the plan and possibly your employers contributions but doesnt include earnings or income on your savings. It cant be for more than the amount of the specific needand you cant have other resources available to cover it. Plus, youll have to pay both income taxes and a 10 percent penalty on the distribution.
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Establishing A Retirement Plan
Working with your business attorney, set up a retirement plan for your new C-corp. You dont have to roll over your 401 funds to another 401, although thats one of the retirement plan rollover options. You can also use a profit-sharing plan, a defined benefits plan, a defined contribution plan or even a combination of these plans. Certain business-specific factors determine which plan is best for your new startup, such as the number of employees and the number of highly paid employees.
Youll also need to appoint a custodian to manage the retirement plan you choose, which is another decision your attorney can help you facilitate.
Fast Process For Receiving Funds
Once the ball is rolling on your ROBS plan, its generally a short time frame before receiving your startup funds. You may have funds in hand in less than a month, sometimes as soon as two weeks. If youre negotiating a startup business deal, such as buying a franchise, or wanting to purchase inventory during a seasonal markdown, a fast turnaround time can make all the difference in closing important deals.
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When You Have A Comfortable Retirement Cushion
If youve been saving steadily over the years and choosing solid investments, you may be ahead of schedule when it comes to meeting your retirement goal. If thats the case, and your job is stable, taking a loan from your 401 may not be too detrimental to your retirement outlook. You could use the money for the purchase of a vacation home, for exampleor, if you have a child in college, as a less expensive alternative to student loans.
Use The Funds To Operate Your Business
Once the QES transaction is complete, your retirement funds can be used by the corporation to begin operating and paying for business expenses! The retirement plan now owns the corporation, and the corporation is cash-rich from selling QES stock.
While the ROBS structure can be complex, the end result is your ability to buy or start a business without going into debt or collateralizing your home. For a more in-depth explanation of the ROBS structure, check out our Complete Guide to 401 Business Financing.
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What Is A 401k Plan Loan
A 401k plan loan is one of a few ways you can borrow money from your 401k early without incurring a penalty.
While 401k plan loans will vary depending on which plan your company offers, a few rules are constant:
- The maximum amount you can take from your 401k is 50% of the vested account amount.
- You may borrow no more than $50,000.
- If 50% of your vested account amount is less than $50,000, you can withdraw up to $10,000.
- You must repay the loan within five years.
Youre borrowing the money from your future self when you take a 401k loan and your future self is going to want that money back with interest.
Thats because when you take the money out, its no longer compounding and accruing interest. This means you will lose the gains on any amount you borrow. The interest rate is there to compensate for the loss in gains.
Now lets take a look at how to borrow from your 401k.
When A Participant Requests A Loan From Your Plan
The participant should receive information describing the availability of and terms for obtaining a loan. Some information that may be provided to a participant is as follows:
- loans are/are not permitted
- minimum dollar amount required to obtain a loan
- maximum number of loans permitted by the plan
- maximum dollar amount permitted
- term of repayment
- interest rate information
- how repayment may be made and
- spousal consent requirements
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Should You Borrow From 401
Your 401 may be a good place to tap into when you need short-term liquidity. However, before tapping into your retirement money, you should explore other sources of cash available.
If borrowing from your 401 is the only option you have, you should understand the loan terms, and have a plan on how you will repay the loan. Using a 401 loan for the right short-term reasons can be the most convenient and lowest-cost of cash available.
Plan to make 401 loan payments ahead of schedule or make a lump sum payment to pay off the loan. The sooner you pay off the loan, the quicker you can return your money to generate returns while avoiding derailing your retirement progress.
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What Reasons Can You Withdraw From 401k Without Penalty
Qualifying medical expenses: If your expenses exceed a certain percentage of your adjusted gross income, you can withdraw funds penalty -free to cover them. Qualified domestic relations order: If a court orders you to give 401 funds to a spouse or dependent, you can withdraw the money penalty -free.
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Considering A Loan From Your 401 Plan
Your 401 plan may allow you to borrow from your account balance. However, you should consider a few things before taking a loan from your 401.
If you dont repay the loan, including interest, according to the loans terms, any unpaid amounts become a plan distribution to you. Your plan may even require you to repay the loan in full if you leave your job.
Generally, you have to include any previously untaxed amount of the distribution in your gross income in the year in which the distribution occurs. You may also have to pay an additional 10% tax on the amount of the taxable distribution, unless you:
- are at least age 59 ½, or
- qualify for another exception.
How The Coronavirus Changed 401 Loans
The CARES Act that was signed into law last month doubles the amount you can borrow from your 401 or 403 to $100,000, or up to 100% of your account, whichever is lower.
Borrowers also can defer loan payments for a year. So you essentially have six years to pay back your loan. The additional year for paying back the loan also applies to existing loans, but check with your plan administrator before you delay any repayments.
Note that interest will still accrue during this time. But you wont owe income tax out the amount you borrowed as long as you pay it back within the loan timeframe.
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Can You Withdraw Money From 401k To Buy A Home
While 401k withdrawal to buy a first home is possible, they are generally not recommended due to steep fees and penalties that arent applied to 401k loans. In reality, you will be making whats known as a hardship withdrawal. This is considered by what the IRS sees as any emergency removal of funds from a 401k to cover an immediate and heavy financial need. Whether or not purchasing a home using your 401k counts as hardship withdrawal is a tricky question. Its a determination that falls to your employer, and you will need to justify this hardship before the withdrawal can be permitted.
How Often Can You Borrow From 401
If your employer allows multiple 401 loans, you can borrow more than one loan at a time. However, any new loan should not exceed the plan loan limit. 401 plans place limitations on borrowing from 401 over a 12-month rolling period. This means that, if you took two loans between February of the previous year and February of the current year, and you have used up the loan limit, you cannot borrow another loan in the same period even if you paid the first loan early. Hence, you will have to wait after the 12-month period to take another loan.
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What Qualifies As A Hardship Withdrawal For 401k
Hardship distributions
A hardship distribution is a withdrawal from a participants elective deferral account made because of an immediate and heavy financial need, and limited to the amount necessary to satisfy that financial need. The money is taxed to the participant and is not paid back to the borrowers account.
Hardship Withdrawal Vs 401 Loan: An Overview
Is it ever OK to borrow from your 401 plan, either as a 401 loan or a hardship withdrawal? After all, your plan is a powerful retirement savings tool and should be carefully handled. Indeed, data from Fidelity shows that the average account balance has climbed to $112,300, as of February 2020.
The recently enacted CARES Act lets you make a penalty-free COVID-19 related withdrawal or take out a loan from your 401 in 2020 with special repayment provisions and tax treatment.
The primary advantage of saving in a 401 is the ability to enjoy tax-deferred growth on your investments. When youre setting aside cash for the long term, a hands-off approach is usually best. Nevertheless, there are some scenarios in which taking money out of your 401 can make sense.
Before you pull the trigger, though, its important to understand the financial implications of tapping your retirement plan early. There are two basic avenues for taking some money out before reaching retirement age.
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