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Is It Ever Smart To Borrow From Your 401(k)?

May 30, 2018 · 6 minute read

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Is It Ever Smart To Borrow From Your 401(k)?

Retirement may seem like a long way down the road, but investing in a 401(k) (and leaving that money untouched) is still an important part of your financial plan. And that’s especially true if your employer matches your retirement contributions.

A 401(k) isn’t just a savings account for you to tap into later; it has tax benefits and, although all investing comes with the risk of loss, it has the opportunity to accumulate returns on your investments over time. Plus, if your employer matches your contributions, that’s free money.

Unfortunately, you can’t treat your 401(k) like a checking account. Taking money out of your 401(k) before you hit retirement often comes with penalties. Even if a 401(k) withdrawal or a 401(k) loan sounds like a short-term solution when you need cash, it could cost you in the long run.

In general, retirement planning can be a little confusing. There are a lot of options out there—401(k) plans, Traditional IRAs, and Roth IRAs, to name a few. But if you’re one of the 54 million Americans who have an employer-sponsored 401(k), then contributing money to your plan can be as straightforward as an automatic deduction from your paycheck. You can even use this retirement calculator to figure out how much you should be setting aside.

Taking money out of your 401(k), however, isn’t as easy as putting money in. There are a few ways to do a 401(k) withdrawal, but there is often no way to do a 401(k) withdrawal without penalty before you reach retirement age. If you need money quickly to pay for bills, emergency expenses, or even home renovations, then a 401(k) loan may sound especially tempting.

After all, you might think you’re simply loaning money to yourself. And while that’s true, there are also penalty fees involved. Here’s what you need to know about a 401(k) loan before withdrawing from your retirement account.

What is a 401(k) loan?

Some 401(k) plans offer an option to take out a loan from your retirement account, and then pay it back over time. According to a comprehensive survey of retirement plans from the Employee Benefit Research Institute , 53% of 401(k) plans offer a loan provision. You need to ask your 401(k) administer if your plan offers these loans.

There are a number of federal rules governing 401(k) loans . For example, you can’t borrow from an old 401(k)—ie. a 401(k) plan tied to a company you no longer work for.

You can roll a 401(k) from a former employer over into an IRA, but you cannot borrow from an IRA. Additionally, you can only borrow up to either $50,000 or 50% of your vested account balance —whichever is less. If you have less than $20,000 in your account, you are able to take out $10,000 of the total vested balance.

A 401(k) loan is repaid through an ongoing payment plan, much like any loan, but with parameters and caps set by the IRS. The loan must be repaid within five years in most cases. And you have to pay interest (yes, to yourself) on the loan. Often the interest rate is the prime interest rate set by the Federal Reserve plus 1%.

If your 401(k) plan doesn’t allow for loans, then you can withdraw cash from your 401(k) instead. This is called a distribution. A distribution is subject to a penalty from the IRS.

Despite the costs and restrictions associated with 401(k) loans, about 18% of people who are eligible to take loans from their 401(k) had existing loans at the end of 2015. That is a number that has stayed relatively consistent since the mid-90s; So most years, about 20% of eligible 401(k) holders have 401(k) loans out.

Can you take money out of a 401(k) without a penalty?

Taking money out of a 401(k) typically comes with a penalty. If you choose to make an early withdrawal before the age of 59 and a half, then you will be taxed on the money as income, and you may have to pay a 10% penalty.

There is one way to do a 401(k) withdrawal without a penalty: a hardship distribution .

This requires that you show an “immediate and heavy financial need.” The 401(k) hardship distribution is limited to the amount that meets your need and will be taxed as income—but it may or may not be subject to the 10% penalty. You cannot repay this withdrawal back to your 401(k), like you can with a loan, and you can’t make contributions to your 401(k) for six months after the hardship disbursement. (The assumption is that you need the money and therefore can’t afford to make a contribution anyway.)

A 401(k) loan doesn’t have the IRS’ 10% penalty—unless you don’t repay the loan—but it has other hefty costs.

Why Taking Money out of a 401(k) Isn’t a Good Idea

Even if you intend to pay back the money and you think borrowing from your future-self doesn’t sound too bad, there are still a few 401(k) loan or withdrawal costs you should consider:

401(k) Withdrawal Penalties

If you don’t repay the loan on time or per the specific repayment terms of your loan, then it will be considered a 401(k) disbursement and will be subject to 401(k) withdrawal penalties. About 10% of 401(k) loans do not get repaid.

Employment Issues

If you leave your job, then the 401(k) loan will come due or be subject to that disbursement penalty. You used to have 60 days to repay the loan after leaving your job. However, under the new tax law signed in December 2017, you now have until October of the year after you leave your job to repay your 401(k).

Loss on Future Earnings

You’ll lose out on the investment returns you could be earning. The money in your 401(k) is invested with the potential to gain returns in the market over time.

While those returns were lower during the recession, over the last 40 years, the market has seen a 10% average return on retirement investments. By taking money out of your 401(k), you’re potentially foregoing an 8% return on the money you withdraw.

Paying Extra Taxes

You have to pay back the 401(k) loan with post-tax money. Contributions to your 401(k) are pre-tax, meaning you don’t pay taxes on them. But when you’re paying back your loan, you have to use money you’ve already paid taxes on. For example, if you take out a $1,000 401(k) loan with a 4% interest rate, then you’ll need to pay back $1,040. If you’re taxed at 25%, then you’ll have to earn $1,300 pre-tax in order to make those payments. And you’ll be taxed on that money again when you withdraw it from your 401(k) during retirement.

Alternatives to Taking Money out of Your 401(k)

A study from the Pension Research Council found that about 40% of 401(k) loans are used to pay off other debt, and 30% are for home repairs or improvements.

All other 401(k) loans are used for consumption, odds and ends, and extra purchases. Of course, the first question you should ask yourself before taking a loan from your 401(k) is: Do you really need this money?

If you do need cash, there are other ways to take care of your expenses without having to tap into your 401(k). If debt is the issue, consider consolidating or refinancing your debt, or negotiating with your creditors. If you are dealing with an emergency expense, or you need to tackle home repairs, a personal loan could be right for you.

A personal loan can be used for any personal expenses, though many people use them to pay off and consolidate existing debt, cover unforeseen expenses, or pay for home renovations.

Personal loans typically come with three to seven-year repayment periods and can have either fixed or variable interest rates. SoFi personal loans offer a range of rates based on your career, education, and credit history.

Although personal loan interest rates might be higher than 401(k) loan rates (and you aren’t paying the money back to yourself), a personal loan can still end up costing you less. Not only is it less risky, but choosing a personal loan and skipping a 401(k) loan allows you to take advantage of the valuable tax benefits and market returns a 401(k) offers.

Before you take money out of your retirement savings, consider a SoFi personal loan. Learn more about SoFi personal loans today, and get a rate quote in just two minutes.


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