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If you're having financial troubles, you might look anywhere for money. For example, if personal loans and home equity lines of credit aren't an option, you might consider a loan from your retirement account, but does it make sense?
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Can I Take a Loan From My Retirement Accounts?
You may be eligible to take a loan from your retirement accounts, but some rules apply, and there are also some downsides. Sometimes, though, life happens, and we can't help it. So if you need a 401 k loan or 401k hardship withdrawal, it's always best to talk to your financial planner first to make sure you've exhausted all options and that it makes financial sense.
Reasons You May Need a Loan From Your Retirement Account
Before taking a 401 k loan, always make sure you've looked at other possibilities. If you're in a bind or have a significant financial goal, though, sometimes the only option is to borrow from your 401 k.
Here are some common reasons employees borrow money from their retirement savings.
- Get out of high-interest debt
- Pay college tuition
- Pay taxes, especially back taxes
- Repair or renovate your home
- Make a down payment on a house
- Pat medical expenses
Is It a Good Idea To Take a Loan From My 401K and IRA
Deciding if you should borrow against your 401 k is a personal decision. It's best decided with your financial planner so you can review the pros and cons and see how it relates to your personal financial situation.
In some cases, it makes sense to borrow from your retirement savings. For example, if you have an immediate financial emergency and don't have the funds, the interest and fees you'll pay on a 401 k loan will be less than what most short-term loan lenders charge.
However, you take certain risks when you borrow from your 401 k.
Can I Borrow From My 401K?
Some employees, but not all, can borrow against a 401 k. Each plan administrator has different rules regarding how much you can borrow and how the repayment schedule and requirements work.
In general, here's how to take a loan from your 401 k.
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How It Works- 401K Loan Rules
Each plan administrator can create separate rules, but according to the IRS, employees may borrow the greater of 50% of their vested account balance or $10,000 with a maximum amount of $50,000.
Again, no employer must allow 401 k loans, though. The IRS rules apply to those who choose to offer the option to borrow from a 401 k.
401K Withdrawal Penalty
If you don't make your payments on time, it's considered a default. You'll pay taxes on the income since you didn't repay it, and if you're younger than 59 1/2, you'll pay a 10% 401 k early withdrawal penalty.
401K Loan Limits
We discussed the 401k loan limits according to the IRS above, but there are limits to how much you can borrow if you need a subsequent 401 k loan.
According to the IRS, you can have more than one loan, but the new loan plus the existing loan cannot exceed the plan or IRS limits.
Here's an example using the IRS loan limits.
You have a 401 k balance of $150,000, and it's a fully vested account balance. According to the IRS, you can borrow up to $50,000 from your 401 k balance.
Initially, you borrow $25,000 with a 3-year loan repayment period. However, a year later, you need another loan. Your outstanding balance is currently $21,000. According to the IRS, the maximum amount you can borrow is calculated as follows:
First, figure the difference between the highest loan balance and the current balance ($25,000 - $21,000 = $4,000). Next, deduct the difference from the $50,000 maximum loan amount ($50,000 - $4,000 = $46,000) and then ($46,000 - $21,00 = $25,000).
The loan limit for the second 401 k loan is $25,000.
401K Loan Repayments
The IRS requires most 401 k loans to be repaid within five years. However, if you use the funds for a down payment on a primary residence, you may have up to 25 years to repay it.
You must make substantially equal payments covering principal and interest, with payments occurring at least each quarter. Some employers offer payroll deductions to make payments more manageable and to ensure you don't default on the loan.
Each plan administrator determines the interest rate; however, it's supposed to be similar to the interest rates you'd receive at a bank.
The good news, however, is the interest you pay is interest to yourself, unlike a loan where the interest goes to the lender.
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Tax on 401K Loans
Your 401 k contributions are tax-deferred, but since a 401 k loan isn't income, you usually don't pay income tax on them. There is an exception, though.
If you don't pay the loan as required, the money left becomes taxable income, taxed at your ordinary income tax rate. If you make your loan repayments on time, though, there aren't any tax implications for borrowing money from your retirement fund.
Before you take out a loan from your 401 k, understand the risks you take:
- You may not be able to make contributions while you have an outstanding balance. How long you cannot make contributions depends on the plan, but even a few missed contributions can be detrimental to your retirement savings.
- You lose the compound earnings effect. Withdrawing money from your retirement savings means it's not invested and earning money. As a result, the interest rate you'll pay usually doesn't compare to most accounts' earnings.
- The payments you make (principal and interest) are after-tax dollars, unlike the contributions you would make to your 401 k.
- If you leave your job (willingly or not), you have until the next tax filing date to pay the loan off in full. After that, you'll owe income tax on the remaining balance if you don't. You may also pay the penalty if you are younger than 59 1/2.
Can I Borrow From My IRA?
Unlike a 401 k, you cannot borrow from an IRA. However, the IRS allows other ways to get your hands on the funds, including hardship withdrawals if they meet specific requirements.
How It Works
You can withdraw funds from your IRA anytime, but if you want to do it without penalty, it must be for an allowed reason.
People commonly withdraw funds from their IRA to roll them over to another retirement account.
There's a loophole, though. If you need the money for something short-term and can repay the funds within 60 days, you can withdraw the funds, take care of your financial needs, and pay the same account back within 60 days, and you won't pay an early withdrawal penalty.
IRA Withdrawal Penalty
Like the penalty for withdrawing from a 401 k, there's a 10% penalty for early withdrawal from an IRA. If you're younger than 59 1/2, it's an early withdrawal. But if you can wait until at least age 59 1/2, you only have to worry about the income taxes owed for the money you withdraw, unless it's a Roth IRA.
You may avoid the penalty if you meet one of these exceptions for an IRA hardship withdrawal:
- You're making an IRA withdrawal for a home purchase, and you're a first-time homebuyer
- You're adopting a child
- You're paying for qualified education expenses
- You're permanently disabled
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IRA Taxes and Fees
Any money withdrawn from your IRA will create a tax liability unless you have a Roth IRA. With a Roth account, you contribute after-tax dollars, so you've already paid the taxes on the funds. Therefore, you won't incur taxes or fees if you only withdraw your contributions.
However, if you withdraw any income (earnings), you'll pay the 10% penalty (if younger than 59 1/2) plus taxes on the income.
The 10% penalty applies to traditional IRAs, too, if you're younger than 59 1/2, and you'll pay taxes on all funds withdrawn.
The largest risk of withdrawing funds from your IRA is the loss you'll experience in retirement. Taking money out now to satisfy a short-term financial issue can create longer-term financial issues in retirement.
You'll lose the compounded earnings and start 'from scratch' when you invest in your IRA again.
Benefits of Borrowing From Retirement Accounts
There are some benefits to borrowing from an eligible retirement plan, whether a 401 k or IRA, including the following.
Speed and Convenience
You don't have to complete a loan application or do a credit check to get a 401 k loan. Most plans allow you to request the loan online and have the funds in your bank account within a few days. It could be helpful if you have an immediate financial need, such as funeral expenses or another major emergency.
Most plans have the standard five-year repayment period, but you can repay the loan as quickly as you want. In addition, most employers allow automatic payroll deductions or flexible repayment period options, such as quarterly payments rather than monthly.
Typically, there aren't any charges for a 401 k loan. If your plan charges an origination fee, it's usually minimal and much lower than most lenders charge.
The interest you pay also goes to your account, not the lender. So while it's an expense because it comes out of your bank account, it benefits you, so it's not a cost in the long run.
Retirement Savings Can Benefit
In some cases, you might pay back more interest than the investments your 401 k was in earned. But, again, this would benefit your retirement savings because you'd put back more than the account would have earned if you left the money in it.
Alternatives to Retirement Account Loans
If a 401 k loan isn't right for you or your employer doesn't offer it, here are some alternatives to a loan on your retirement plans.
- Personal loan - If you have good credit, you may get attractive terms on a personal loan and have the funds you need without any tax implications or penalties.
- Home equity line - If you have equity in your home, you can use it with a home equity line of credit. They have a lengthier application process, but the interest rates and fees are typically low. You can also use the funds how you want.
- Cash in taxable investments - If you have taxable brokerage accounts, consider cashing in your investments to cover your financial needs. If you work with your financial advisor, you may offset the tax liabilities by selling some investments at a loss, reducing your capital gains.
Loan From Retirement Account FAQ
401K Loan vs Personal Loan- Which Is the Better Option?
If you don't have good credit or can't get good terms on a personal loan, a 401 k loan may be the better option. There are some benefits when comparing a personal loan vs. a 401 k loan. First, on a 401 k loan, the interest rates are usually low, and you pay yourself, not a lender. However, if you have a 401 k account with high earnings, you might lose money by withdrawing funds now, in which case a personal loan may be better.
At What Age Can You Withdraw From 401K or IRA Accounts?
You can make IRA and 401 k early withdrawals at any time, but if you don't meet the hardship withdrawal requirements, you might pay a 10% penalty. You also pay income tax when you withdraw funds from either an IRA or 401 k plan early.
What Is a Financial Hardship Loan?
A financial hardship loan is a loan you take for serious financial emergencies that you don't have the funds to cover. Some plan loans require you to prove the hardship to be able to withdraw the funds.
How to Pay Off 401K Loan Early?
You can pay a 401 k loan off as early as you want. For example, if you receive an income tax refund, work bonus, or work overtime to have money to pay off your loan early, you can. Your administrator will help you with the payments to ensure you pay the full balance back and get back on track with your retirement plans.
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Can I Use My 401K to Buy a House?
You can use your 401 k to buy a house, but it shouldn't be your first option. If you don't have any other funds, you can borrow up to 50% of your vested account balance or $50,000, whichever is less. Remember, though, you're robbing your retirement assets of these funds, which can be hard to replenish, especially after buying a home.
Will My Employer Know if I Take a 401K Loan
Typically, the administrator of your plan approves 401 k loans. Your employer might know, but it's not required for them to know unless you need to set up automatic withdrawals for loan repayments.
Can I Roll Over the Outstanding Loan Balance From My Retirement Plan Into an IRA?
You can roll any retirement plan into your IRA. If you do it within 60 days of withdrawing the funds, you won't pay taxes or a penalty on the funds.
The Bottom Line
A loan from your retirement account isn't always bad, but it depends on the circumstances. It's always best to exhaust all other options, and if there isn't anything else, talk to your administrator and/or a personal finance professional about borrowing from your retirement plan.