Suppose you’ve been in a position where liquid cash was tight and needed a few hundred dollars to get through to the end of the month. In that case, you might have considered taking out a loan on your 401(k) account. Under IRS rules, as long as you pay yourself back with interest, there isn’t any downside. In fact, if you don’t have any other sources of money available to you at that moment and your loans are structured correctly, it could even be seen as an investment opportunity. Suppose your company offers this option, and you meet the criteria to take out a loan. In that case, it can be one of the most beneficial financial tools available to you right now. However, to understand what the upside is and how to avoid potential pitfalls, we first need to understand exactly the downside of 401(k) loans and how they can also benefit some people.
A 401(k) loan is a specific type of loan that allows you to borrow money from your company’s retirement plan to get cash in your pocket. However, as with other types of loans, you will have to repay this money with interest. A 401(k) loan is an example of a “non-arm’s-length transaction” and therefore treated as a “distribution,” which means it is a taxable event. However, you only have to pay taxes on the amount of money you actually take out and not on the entire amount you loaned yourself.
The process for taking out a loan from your 401(k) is very simple. You go to your company’s HR department and ask for a loan. Then, you will sign a promissory note, agreeing to repay the loan with interest. The funds are sent directly to you from the 401(k) plan, just as if you had made a withdrawal. Since the loan is made by your employer, the money comes from their pocket, not the plan’s assets. The maximum amount that you can borrow is the lesser of 25% of your vested 401(k) account balance or $50,000. However, the rules vary by company, so you should check with your employer to find out the specific rules in your company.
Since a 401(k) loan is a taxable event, you have to pay taxes on the amount of money you actually take out. However, since you are repaying the loan with interest, the IRS treats that repayment as a savings plan, which means you get to deduct that interest repayment from your taxes in the year you pay it back. When you are taking out the loan, you have to estimate the amount of interest that you will have to pay on it. If your estimate ends up being too low, you can pay yourself back the difference at the end of the year, and you won’t have to pay any taxes on it. If, on the other hand, your estimate of how much interest you will have to pay on the loan is too high, you can just pay yourself back the difference at the end of the year. In this case, you won’t have to pay any taxes on the money since you are simply getting back the amount that you over-estimated.
- You get access to the cash you need now: When you take out a 401(k) loan, you get access to cash. Suppose you don’t have an emergency fund or other cash that you can use to get you through a tight financial situation. In that case, this loan can be incredibly helpful.
- You can avoid using a high-interest credit card: If you are in a situation where you are desperate for cash, your only real option is to go to a high-interest credit card. By taking out a 401(k) loan, you can avoid ever having to go that route.
- You can make an investment that will pay you back the loan: If you are taking out a 401(k) loan in order to invest in something that is expected to generate a significant return, such as real estate.
- You have to pay it back: This seems obvious, but it is important to remember. The loan has to be paid back with interest, and it might be difficult to make those payments if your financial situation gets any worse.
- You could be jeopardizing your retirement savings: If you are in a position where you are too financially strapped to ever repay the loan, it could lead to serious problems for your future financial security. Taking out this loan could mean you have to work longer than you had planned, which will reduce your savings for retirement.
- You could be hurting your credit score: If you have to take out a 401(k) loan to pay off high-interest credit card debt, that can help your credit score. However, if you take out a 401(k) loan and don’t pay it back, that can actually hurt your credit score.
You may think you can avoid the downside of 401(k) loans by opting for an early withdrawal. But that route comes with its own penalties and taxes. Suppose you are looking to withdraw the funds before you reach the age of retirement. In that case, you will be imposed income taxes on any profits and may also have to pay a bonus penalty of ten percent. This depends on the type of hardship that you are facing. You can also try to get a hardship distribution when you go for an early withdrawal. The Internal Revenue Service has defined hardship distribution as a heavy and instant financial requirement of the person. It has been said that the amount taken must be required to satisfy the financial requirement that arises for that person. This kind of early withdrawal does not need the person to pay it back. It also does not come with any penalties. There are several different circumstances that are covered by a hardship distribution. These types of hardships can be relative. The person may be going through a hardship that may not qualify them for early withdrawal.
As mentioned, this kind of withdrawal does not need the person to pay it back. But it is a great idea not to go for this type of withdrawal, as it is worse compared to the disadvantages of 401(k) loans on your retirement funds. You should find different ways to avoid those high penalties and taxes and keep your retirement fund intact.
There are plenty of reasons why taking out a 401(k) loan can be a smart move. However, there are also some significant risks that come with that decision. If you are in a tight financial situation right now and you know that you can pay the loan back, there is nothing wrong with taking out a 401(k) loan. However, you should be careful not to make it a habit since that can have serious long-term consequences for your future. Be mindful of the downside of 401(k) loans if you are seriously considering them.