Is Now the Time to Give Yourself a 401(k) Loan?

Shallon Weis |
Categories
Financial Planning

In planning how to finance a large purchase before age 59½, it’s common to consider the idea of taking a withdrawal or a loan from a 401(k) or another retirement account. Taking money from your retirement funds is not a decision to be made lightly and can come with a few undesirable consequences. But the Coronavirus Aid, Relief and Economic Security (CARES) Act has allocated $2 trillion for economic stimulus and relief, including provisions to make it easier and more sensible for some to access their retirement funds. 

If you’re experiencing hardship because of the Coronavirus pandemic, you may want to think about borrowing or withdrawing money from your 401(k) to help. 

What Has Changed Under the CARES Act?

Normally, you can withdraw or borrow up to 50% or $50,000 from your 401(k) savings before age 59 ½. A premature withdrawal usually comes with a 10% penalty and at least 20% automatic withholding from taxes. 

Under the CARES Act, you can now borrow or withdraw up to $100,000 from employer-sponsored and personal retirement accounts, or a combination of the two. The 10% penalty is waived for distributions made in 2020 and there are no mandatory withholding requirements. However, if you don’t pay back the amount you withdrew, the distribution will be taxed as income evenly over the years 2020, 2021, and 2022. If you do pay back the amount within three years, you can claim a refund on those taxes. 

You can also take out up to 100% or $100,000 as a loan and defer payments for up to one year. 

Who is Eligible? 

Not everyone is eligible to take advantage of these 401(k) benefits. If you, your spouse, or a dependent has been diagnosed with COVID-19, you are automatically eligible. Otherwise, if you have suffered from financial hardship due to the pandemic, you may be eligible. This could include a number of circumstances that you, your spouse or a member of your household has experienced, including: 

  • Being furloughed, laid off, or under mandatory quarantine.

  • Having work hours cut, income reduced, or a job offer rescinded or delayed.

  • Being unable to work because of a lack of childcare.

  • Being a business owner who has had to cut down hours or close a business.

Even if you’re still employed, you may be eligible for a distribution from your 401(k) if you have had one or more of these hardships. 

Consider Your Withdrawal Options Carefully 

Consider the impact that a withdrawal from your account may have on compound interest over time. If you’re withdrawing with no plan for paying it back, you may be hurting your finances more in the long run than borrowing from somewhere else. But, especially if you’re experiencing hardships like loss of income, withdrawing money from your 401(k) may make more sense than accumulating high-interest debt. 

Be mindful of taxes in your specific situation. You can either claim your distribution as income all at once or spread it out over the next three years. In most cases, it’s better to spread the income out, as you’ll be less likely to bump yourself into a higher tax bracket. Although if you expect your income to be lower in 2020 than the two subsequent years, claiming the distribution all at once may result in a better tax situation. 

It’s also important to know the difference between taking a withdrawal and a loan from your 401(k). It may make more financial sense for you to take a loan if you plan on staying with your employer and paying back into your 401(k) within the next five years. A loan typically has a lower impact on your long-term retirement savings.

If you make a withdrawal, repayment isn’t required, there’s no penalty and you have a few different tax options. With a loan, repayment is required within a specific time period, usually five years. The loan amount isn’t taxed or given a penalty fee initially, but if you fail to pay it back within five years you will be charged a 10% penalty. In addition, if you leave your employer with an outstanding 401(k) loan balance, you will owe the remainder by mid-October of the next year. If you don’t pay the balance before this date you’ll be charged an early withdrawal penalty. 

When It Makes Sense to Cash Out

Every financial situation is different, but there are times when it makes sense to take a withdrawal or loan from your retirement savings account. For instance, if you’re trying to avoid a high-interest loan for a large purchase, a loan from your 401(k) may be a better option. Instead of paying interest to a credit card company or a bank, you’ll be paying interest back to yourself. And even with double taxation, the cost of a 401(k) loan is usually much smaller than other options for tapping cash liquidity. 

It’s also a good idea to consider a withdrawal or loan from your 401(k) in an emergency situation. If you’re at risk of eviction or foreclosure on your house, you might want to use retirement savings to pay rent or mortgage costs. It may also make sense if you’re having trouble paying for medical bills, prescription medications, essential food, and hygiene products or other basic needs for you and your family. 

If you’re struggling to figure out whether taking a withdrawal or loan from your 401(k) is right for your needs, consult a financial professional to figure out what your best plan of action may be.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2024 Advisor Websites.