Even though you already know not to use your retirement funds for irrational purchases, there are a few circumstances where borrowing money might be acceptable.
A significant portion of personal wealth comes from retirement accounts: As of the end of the first quarter of 2018, the average 401(k) plan account balance at Fidelity Investments was $102,900.
You should let the money accumulate over the course of your career to get the most out of your retirement plan. Your 401(k) plan’s best friends are time and compounding market returns.
However, sometimes more drastic measures, such as taking out a plan loan, are required due to emergencies or long-term planning objectives.
Participants in the plan are aware that the funds are confidential, but they might encounter circumstances in which their 401(k) is their largest source of capital, according to James A. Cox, financial advisor at Harris Financial Group in Richmond, Virginia.
You are typically permitted to withdraw up to 50% of your vested account balance, up to a maximum of $50,000, whichever is less, depending on whether your plan permits borrowing. You have five years to repay the loan.
Thats different from simply withdrawing money. In that case, your plan administrator will deduct 20% of the amount for income taxes, and if you are under the age of 5912, you will incur a 10% penalty.
Last but not least, a “hardship distribution” is when an employee withdraws from their own contributions to pay for an “unforeseeable emergency,” according to the IRS. “.
These distributions are not returned to the plan; instead, they are included in your taxable income and may be subject to additional taxes. This means they permanently lower your account balance at work.
When you can borrowJamie Grill | Getty Images
When you withdraw funds from your plan, they are no longer eligible for long-term market returns.
It’s best to use your emergency fund first if you have one. It is even better to include that repayment in your budget if you are managing debt.
Even your boss wants you to keep your retirement savings out of your hands.
Given that, here are three extreme situations that might necessitate a 401(k) loan:
You have an immediate emergency. Aaron Pottichen, president of retirement services at CLS Partners in Austin, Texas, said, “Say you have no money in your health savings account and you need to meet the deductible on your high-deductible health-care plan.”
He’s talking about the tax-advantaged health savings account that people can use to pay for certain medical costs. Its also known as an HSA.
You have an immediate need for money, but you can’t get a competitive interest rate because of your credit. Ask yourself what you can repay in five years.
Your long-term financial goals are being hampered by high-interest debt, which you must pay off. If the interest rate on your 401(k) is lower than what your creditor is offering you, then this is the case.
What’s your cheapest interest rate and how quickly can you pay off the debt? are the two main considerations if you’re in debt repayment mode, according to Pottichen.
What not to doThomas EyeDesign | Vetta | Getty Images
In the worst case scenario, you would borrow money from your retirement account, fail to pay it back, and end up with even worse financial circumstances.
Dont borrow if youre planning on leaving. Whether you lose your job or get fired, you might have to pay back the entire loan balance within 60 days to avoid having the money you borrowed treated as a taxable distribution.
Dont ignore your debt-to-income ratio. Treat your plan loan just like any other form of credit. The general rule of thumb is that only 36% of your gross monthly income should be used to pay off debt.
This is known as the debt-to-income ratio.
Dont blow off your plans rules for loans. A 2016 study from Aon Hewitt revealed that six in 10 employers have said theyd take steps to curtail the leakage of assets from retirement plans. Those actions include limiting the number of loans available or the amount of money thats eligible for borrowing.
Plans can also set their own repayment terms and deadlines, which you must abide by.
“Taking a 401(k) loan reduces your take-home pay because it comes out of payroll,” said Cox. “You must adhere to the payment schedule or fully remit the outstanding balance.” “.
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What is the current interest rate on 401k loans?
Most 401(k) loans have interest rates of prime rate plus 1% or 2%. The prime rate as of September 2022 is 5. 5%. Since you are borrowing with your own funds, no lender receives interest. Instead, the interest is paid back into your 401(k) account.
Can I pay off my Fidelity 401k loan early?
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.
What is the downside of taking a loan from 401k?
Before taking out a loan, keep in mind that you’ll have to pay it back with after-tax money and that you might lose investment earnings while the money is out of your account. If you lose your job, you’ll have to pay back the loan faster—by the deadline for filing your subsequent tax return.
Do 401k loans earn interest?
For those in need of money, this may seem like a good option, but there are some factors to take into account. The loan will have interest attached to it. Even though the interest payment is returned to your account, think about the potential earnings if you had invested the loan amount instead.