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Your retirement accounts should be used to invest and save money rather than borrow it. A 401(k) loan, however, might be beneficial for your circumstance if you find yourself in a situation where you need to borrow money and have few other options.
You can make pre-tax contributions to an employer-sponsored retirement plan called a 401(k). There are fees associated with early withdrawals from your account, but if you can adhere to a few specific guidelines, you may be able to borrow some of your 401(k) funds.
A 401(k) loan is exactly what it sounds like: you take out a loan against your own 401(k) account and repay it over time. A 401(k) loan, however, is not a true loan because neither the lender nor your credit score are checked. Your 401(k) company may have its own loan ceilings, but the IRS caps the amount you can borrow at $50,000 or 50% of your vested 401(k) balance, whichever is less.
However, you will just have to pay yourself back the origination fees and interest. You must ask your employer about their 401(k) loan options and complete the necessary paperwork in order to borrow money from your 401(k).
Quick tip: There is always a chance that borrowing from a retirement account will cause you to miss out on growth and compound interest. If your credit is good, you could also try getting a personal loan or, for smaller purchases, a credit card with 0% interest.
401(k) loan rules
If you plan to use a 401(k) loan, there are many crucial guidelines to remember.
“The interest rate on 401(k) loans tends to be relatively low, perhaps one or two points above the prime rate, which is less than [what] many consumers would pay for a personal loan,” says Arvind Ven, CEO of Capital V Group located in California. “Also, unlike a traditional loan, the interest doesnt go to the bank or another commercial lender, it goes to you.”
Ven also cautions that the brokerage firm managing your 401(k) will notify the IRS on Form 1099-R if you are unable to repay your loan.
“By that time, it’s treated as a distribution and comes with more fees, so it’s important to stay on track with payments.” “.
Quick tip: To prevent the IRS from classifying the loan balance as a distribution, 401(k) loan payments must be made at least quarterly. You should try to make a payment on your 401(k) loan even if you are falling behind and communicate with the brokerage to get back on track and avoid paying taxes and penalties.
Pros and cons of a 401(k) loan
Some might argue that taking out a 401(k) loan is a smart move, while others might disagree. It is crucial to weigh the benefits and drawbacks in order to choose the course of action that is best for your circumstances.
If you need money right away, you can get it. The main advantage of a 401(k) loan is that you can quickly access money to pay for expenses like medical bills or home repairs. Since payments are deducted from your paychecks, there is no credit check, and the repayment guidelines are also flexible. When you are between jobs, you won’t have to be concerned about finding the money to make loan payments.
Any interest paid goes back to you. “With a 401(k) loan you are paying interest to yourself rather than a third-party bank or credit card company,” says Bethany Riesenberg, a CPA at Spotlight Asset Group. “In many cases, the interest rate is lower than credit card rates, so it may make sense to take out a 401(k) loan to pay off high-interest debt you have.”
Withdrawn funds wont benefit from market growth. The biggest negative is that your 401(k) withdrawals won’t grow in value. Even if you pay the money back in full, with interest, within five years, you might not be able to recover the money you lost if market growth was higher than average during those five years.
Youll have to pay fees. Another issue is fees because taking money out of your 401(k) is not free. Even though you’ll be paying interest to yourself, you’ll still have to fork over additional funds. In addition, if you take out a 401(k) loan according to your plan, you might have to pay both an origination fee and a maintenance fee.
Payments made toward the loan are taxed. Even if you use the loan to purchase a house, you should keep in mind that loan repayments are made with after-tax money, and you’ll be taxed again when you withdraw the money in retirement.
You might not be able to contribute to your 401(k). If you have an outstanding loan, some plans won’t let you make 401(k) contributions, according to Riesenberg. This means that if you take five years to pay off the loan, it will be five years before you can add money to your 401(k). As a result, you will have missed out on both the chance to save and the tax benefits associated with making 401(k) contributions. “.
Furthermore, if your employer matches your contributions, you will lose out on those during the years that you aren’t making 401(k) contributions.
If you leave your employer, you might have to pay it off right away. Finally, if you leave your job before paying back the 401(k) loan, that is a significant disadvantage to take into account. In this situation, your plan sponsor might demand that you pay back the entire 401(k) loan. Additionally, the IRS mandates that borrowers repay their entire 401(k) loan balance by the deadline for filing their tax returns for that tax year. The amount may be taken out of your vested 401(k) balance and treated as a distribution (subject to a 10% withdrawal penalty) if you are unable to meet those requirements.
401(k) loan vs. 401(k) withdrawal
If you want to repay the loan with contributions to your retirement account, you should use a 401(k) loan. However, if you simply want to withdraw money to pay for an expense, this would count as a withdrawal.
It’s typically not advised to take money out of your 401(k) early because you’ll be charged penalties and taxes if you’re under the age of 59 12.
Consider the following scenario to see how a 401(k) loan operates: Suppose you needed $25,000 right away to settle high-interest debt and your vested 401(k) balance is $60,000. The most you could get from a 401(k) loan is $30,000 (the lesser of $50,000 or 50% of your vested balance).
However, in this situation, you could borrow $25,000 from your plan (less any additional fees), leaving you with a $35,000 balance in your plan, and there would be no taxes or penalties associated with your loan. You’ll make a payment of $235 every two pay periods if the loan has a five-year term, a 5% interest rate, and is repaid through biweekly payroll deductions. 89 ($471. 78 each month). That means youd end up repaying $28,306. 85 in total ($25,000 + $3,306. 85 [in interest] = $28,306. 85).
Your loan will be completely repaid in five years, at which point your 401(k) account will reflect all of the loan and interest payments you made ($35,000 + $28,306). 85 = $63,306. 85).
Instead, let’s look at an example of an early 401(k) withdrawal: If you withdraw from your 401(k), you’ll need to withdraw more money due to penalties and taxes in order to net $25,000 if you do so. If you had to withdraw $39,683 in this case, taxes and penalties would total $14,683 (based on a 20% federal tax rate, a 7% state tax rate, and a 10% early withdrawal penalty). This means that your 401(k) balance, which was originally $60,000, is now $20,317. If you took a 401(k) loan, your balance would be almost $15,000 higher.
According to Riesenberg, some plans have hardship withdrawals that can provide money in very specific emergency situations, but you must have a pressing financial need.
Riesenberg also adds that if you are allowed a hardship withdrawal from your 401(k) account, youre not required to pay the 10% early withdrawal penalty
Quick tip: Your employer has the final say on whether to approve the withdrawal as a hardship withdrawal, and they may have very strict requirements for what qualifies (including documentation requirements).
The bottom line
If you have exhausted all other options, 401(k) loans may be the best way to pay off high-interest debt or cover a serious emergency. On the other hand, if you can’t afford to repay the loan or if you quit your job before the repayment period is up, borrowing money from your retirement account carries a lot of risk.
Most of the time, it is safer to use other methods of borrowing money instead of your retirement funds, such as a low-interest personal loan or 0% APR credit card. Before making a 401(k) loan decision, you should speak with a financial planner who can assist you in weighing all of your options and project how the loan will affect your retirement.
How long do I have to pay back a 401k loan?
Generally, you have up to five years to repay a 401(k) loan, though the term may be as long as 25 years if you’re using the funds to purchase your primary residence.
Do 401k loans have to be repaid before you retire?
While you might be able to continue making payments on the loan, most businesses require immediate repayment when you depart. And if you don’t pay what’s due, you might receive an unexpected tax bill.
How do you repay a 401k loan?
Repaying a 401(k) Loan You must accept the terms of repayment when you apply for your loan. Most workers set up automatic payroll deductions to pay back their loans, pausing contributions until the loan is paid in full. You might have to pay back the loan earlier than the loan term if you lose or leave your job.
Can you make extra payments on a 401k loan?
Yes, 401(k) plan loans can be repaid early without incurring a fee. The option of repaying loans through regular payroll deductions, which can be increased to pay off the loan earlier than the required five years, is provided by many plans.