The Difference Between 401k Loans vs. 401k Early Withdrawals
By Gust Contributor, Anum Yoon
If you need a large amount of money, you might be tempted to dip into your retirement fund. Many 401k plans let you borrow money or take an early withdrawal. Both have their pluses and minuses. However, they have one thing in common: If you take out money, you’ll typically have saved less when it’s time for retirement. The consequences of taking a 401k loan or a 401k early withdrawal could cost dearly in retirement. Don’t take this decision lightly or in your later years, you might be forced to change your lifestyle or postpone your exit from work.
Taking early withdrawals from your 401k may be relatively simple, but that doesn’t mean it’s the correct decision for you. When withdrawing from your retirement account, compare the two formats — loan and early withdrawal — and decide which makes the best financial sense for you.
Considering a 401k Loan from Your Retirement Account?
Some people like the idea of a 401k loan because you’re essentially borrowing from yourself and paying yourself back. Because of this arrangement, you don’t have to go through a credit check, so the loan process moves along quickly. According to Nick Thornton’s “Why 401k Loans aren’t Always a Bad Thing” at BenefitsPro.com, almost 90 percent of 401(k) plans offer loan options. Still, proceed cautiously before taking the plunge.
Benefits and Details of Your 401k Loan
- Purpose of a 401k loan: You’re allowed to use a 401k loan for any reason. If you think it’s a good idea, it’s yours. However, some retirement plans require spouses of married employees to sign off on loans.
- Amount of a 401k loan: Your maximum loan size depends upon whether you’re vested in your retirement plan and the particulars of your company. A quick review; if you’re vested, your retirement account still belongs to you if you leave a company. Your personal contributions are always fully vested with a 401(k). Depending upon your plan, you may or may not have access to your employer contributions.
You can take out no more than 50 percent of your vested account balance, and the total loan is capped at $50,000. However, if your vested amount is less than $10,000, you’re allowed to borrow up to that amount. Some plans set a minimum amount that you can borrow.
- Tax implications of a 401k loan: In general, your cash withdrawal from a 401k loan is not taxed, unless you fail to repay it. Then you will be subject to ordinary income tax and if you’re younger than age 59 1/2, a 10 percent penalty.
- Payback: All interest payments are paid into your 401k account. There may be additional fees when borrowing from your 401k.
The 401k Loan Bad News
If for some reason you go three months without a payment, the IRS considers the loan to be taxable income. If you’re less than 59 ½ years old, you also have to pay a 10 percent early withdrawal penalty. Perhaps the most sobering requirement: If you leave your job for any reason, you have 60 days to pay back the loan. If not, those two IRS penalties go into effect.
- Impact at retirement: Retirement money that you’ve borrowed will not accrue interest until you’ve paid it back. Depending upon the amount you’ve taken out, it can make a big dent in your fund.
- Some employers will disallow new 401k contributions if there’s an outstanding loan, thus compromising your future retirement nest egg.
- If you lose your job, you may be required to repay the loan, typically within 60 days.
Wondering About 401k Early Withdrawals?
Taking an early withdrawal means you have no intention of paying the money back. Since the 401k is supposed to be your retirement account, both the IRS and employers frown upon this. Therefore, the conditions are quite strict.
- Purpose: If you’re younger than 59 ½, the IRS doesn’t want you to remove money from your 401k. Some plans do allow specific hardship distributions for large and sudden needs. These might include funds for unexpected medical expenses, down payment or damage repair for a primary residence, prevention of foreclosure or eviction, funerals and higher education. Not all plans recognize the same financial stressors.
If you’re old enough to retire but are still working, the IRS doesn’t limit early withdrawals. However, your individual 401k plan might have its own restrictions. You’ll need to check your employer’s rules.
- Amount: You can’t take out more than you’ve put in or more than you need to address the hardship.
- Tax implications: For most 401k withdrawals, you pay income tax on the amount you withdraw as well as a 10 percent penalty. Combined, those two requirements take a large chunk out of any money you pull out.
However, certain employees with Roth 401k plans are a little more fortunate. If you’re at least 59 ½ and it’s been at least five years since the start of the year you began contributing, your withdrawal isn’t taxed. You’re also not penalized.
- Payback: You don’t have to pay back the amount you withdraw. That’s the beauty of it.
- Impact at retirement: The lack of repayment is also the curse of the withdrawal process. You won’t accrue any more interest on the money you took out, and it won’t be available when you’re ready to retire.
Whether you borrow from your 401k or take an early withdrawal from your 401k, you’re going to take a financial hit at retirement. Only you can decide if using the money now is worth the sacrifices you’ll face in the future. For most people, retirement funds are best left untouched until you’re ready to leave the workplace behind permanently. Not thinking about the long run can result in a cash shortfall in retirement.
Anum Yoon is a blogger, freelance writer and everything in between. She loves writing about personal finance, as seen on her blog, Current on Currency. When she’s not budgeting for her traveling endeavors, she’s on Twitter @anumyoon – so check out her latest updates.